US Perspectives: Earnings Reports Trump Economic Data

Economic news wasn't a disaster--just a little slower than expectations, which had gotten a bit out of hand.

Robert Johnson, CFA 18.01.2011
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United States markets managed a rally last week, their seventh weekly increase in a row, despite economic data that can best be characterized as mixed, as well as negative news that China was raising reserve requirements in yet another attempt to slow inflation.


The apparent cause of the rally appeared to be better-than-expected corporate earnings. Alcoa kicked off the week with news that strong aluminum demand and a positive price environment pushed earnings higher than expectations. Tech bellwether Intel also surprised on the upside on the back of accelerating demand from businesses. Then on Friday a positive earnings report from J.P. Morgan turned a lackluster market bullish, despite more disappointing economic data.


The economic news wasn't so much an out-and-out disaster--just a little slower than expectations that had gotten a bit out of hand. Retail sales were healthy but slower than November. Industrial production was fine, but a weather-related boost from utilities saved the day. Even initial claims data that had been improving for weeks moved the wrong way as claims offices worked their way through holiday-related backlogs.


Inflation last month was high but not far off the consensus forecast. Nevertheless, I remain worried that consumer incomes lagging inflation will throw cold water on a recovery that had showed signs of wanting to break into a gallop. A smaller-than-expected trade deficit was one of the few positive highlights of the week, causing economists to boost their fourth-quarter GDP estimates once again (most are now in the 3.25%-4% range).


Industrial Production Growth Back in the Black

Industrial production managed to bounce back in December, matching expectations after a weaker November. My premise has been that production growth would be back-end-loaded this year, with a lot of the growth coming in the last month and quarter of the year as businesses put off spending as long as they could given all the uncertainty.


In December, those same businesses face the use-it-or-lose it budget phenomenon, where budgeted funds not spent by the last day of the year are lost. Eric Landry, head of our industrials team, sums up the report:  

The December reading for the nation's industrial activity inched up 0.8% from November's downward-revised 0.3% sequential gain. Last month's increase was the highest since July's 0.1% sequential gain according to our calculations. Manufacturing increased a more modest 0.4%, while the volatile utility space posted a 4.3% month-to-month gain. The index appears to have broken out of its four-month funk, but because December's results were aided by utilities, things could reverse in short order. Output of consumer durable goods fell 0.5% from November, with all subgroups except home electronics declining. The output of nonenergy nondurables was little changed. Encouragingly, output of business equipment increased 0.6%. For the year, total industrial production was up 5.9%, the index's first annual December increase since 2007. Given the modest uptick in consumer activity (notwithstanding December) and generally improving economic conditions, we expect overall industrial production to continue its mid- to high-single-digit year-over-year expansion throughout 2011. Our current thinking is that these two positives will more than offset the loss of an inventory restocking dynamic that was so beneficial in prior quarters.

 Retail Sales Jump 0.6%, 7.2% Annualized

While the official government retail sales growth figures met my expectations of 0.6% (7.2% annualized) for the month of December, they did come in a bit short of consensus estimates of 0.8% growth last month. I warned a month ago and again a week ago that earlier-than-usual holiday promotions and weather would weigh on December's final results.


The variance by category this month was the widest I have seen in some time; nonstore retailers (think Amazon), building materials, furniture and autos all showed growth in excess of 1%. Meanwhile, electronics, food and beverage stores, clothing stores, and department stores all showed declines. Restaurants managed a 0.2% increase, which is still weak but better than the 0.1% growth reported in the prior month.


We all tend to get bogged down in month-to-month reports, but the full-year data were far more interesting in 2010. For the full year, retail sales jumped 6.6%, the biggest increase since 1999. The data were not particularly volatile, either, with only two months (May and June) showing a decline.


Despite a small pullback in growth rates during the month of December, retail sales growth for the December quarter was well in excess of 12% on an annualized basis when compared to the prior three months, showing sharp acceleration from the first three quarters of the year. Although strong retail sales are impressive, results this strong will be hard to match. A small back-off in retail growth rates will be no reason to panic, especially in light of the poor real wage growth data for December.


Consumer Price Index Leaps 0.5% on Higher Food and Energy Prices

Core inflation for December was a modest 0.1%, while food and energy prices forced the headline CPI up a significant 0.5%. Those prices aren't showing any signs of backing off in January. A 1.1% jump in the Producer Price Index the day before does not bode well for the inflation outlook in the months ahead. Again, backing away from a monthly focus, the year-over year-inflation rate all-in-all moved up to 1.5% from 1.3% the prior month, representing a seven-month high, though about half of that gain is related to food and energy.


Real Weekly Wages Plunge, and the Economic Caution Flag Is Out

The inflation report is most troubling when I compare hourly wage growth and hour growth data from the week before last week's employment report with last week's report of accelerating inflation. The government's measure of real weekly wages (combining wage rate and hours) fell 0.5% last month and has been down two of the last three months. Wages still provide a slight majority of consumer income (dividends, interest, rent, and government transfer payments make up most of the rest). The three-month decline in real weekly wages is not good news. If consumers don't receive the cash, it certainly makes it hard to spend more and keep the virtuous economic cycle going.


On the other hand, the payroll tax cut, improved dividend and interest payments, and increasing rents will take away some of the sting of softening wage income. In addition, December is not a great time to be measuring wage growth, as many income increases are tied to the calendar. That tends to really suppress increases in December and boost increases in January. The fact that this is a relatively long leading indicator gives me a little more time to exercise some watchful waiting. The yellow warning flag is up, but these seasonal changes and the tax decrease keeps me from hoisting a red flag yet.


Better Net Export Data a Relief Valve to Softening Consumer Incomes

While news on the consumer income and spending front could get a little dicey in the months ahead, the shift in spending from foreign goods to domestic goods and services could make up for a least a little of the potential spending softness. During parts of 2010, consumer spending looked really strong, but initially a lot of that spending went to electronics and apparel, two categories that have a high import percentage.


This fixation on foreign goods broke the virtuous cycle (more spending, more production, and more employment, followed by more income and spending), especially in the second quarter. As some consumer spending shifts to domestically produced goods and services, especially health care, we could see a period of GDP improvement even as total consumption moderates. Julie Stralow, a senior health-care analyst at Morningstar, noted that orthopedic supplier Stryker had a better-than-expected December quarter as consumers loosened their purse strings to undergo more elective/deferrable procedures. Dampened health-care spending has held this recovery back when compared with the recovery from the 2001 recession.


Trade Report Shows Surprise Improvement

There are already some signs that import growth has begun to slow. During November imports grew just 0.6%, while exports grew a faster 0.8% causing the trade deficit to unexpectedly fall to $38.3 billion, down significantly from June's disastrous $50 billion report. Consumer goods imports in November fell $0.9 billion, a highly unusual circumstance for a rising U.S. economy. However, some of that improvement could have been because retailers imported their holiday-related goods earlier in the year in anticipation of earlier holiday promotions (early promotion strategies have also distorted retail employment and last week's retail sales).


Inventories Under Control

The good news is that higher inventory levels were not the key driver of industrial production. Sales grew faster than all business inventories for November, causing the inventory/sales ratio to fall back to 1.25 times. That's not far off of its lowest level of the recession (1.24). During November, sales grew an impressive 1.2% while inventories grew a minuscule 0.2%. Given some stronger shipment metrics for December, it is entirely possible the ratio could be flat to down in December. The good news is that low inventories are likely to keep production on the move in early 2011 and the production levels will be particularly sensitive to any upside movements in end user spending. The bad short-term news is that inventory building in the fourth quarter will not be a positive contributor to GDP growth. Inventory restocking and exports have been the two biggest contributors to GDP growth so far in this recovery.


Housing Data Front and Center This Week

This week brings more data on the moribund housing industry. Housing starts are due on Wednesday, with a consensus forecast of 543,000 units on a seasonally adjusted annual rate basis, down about 2% from the prior month. Poor weather, a sloppy permits number the month before, and normal seasonality all weigh on the number.


For the full year 2010, total starts will come in at just under 600,000 units. That's not much better than 2009's dismal 554,000 unit performance, and it's so far below the all-time record high of 2.2 million units that it almost seems inconsequential. It is also well below the 1.5 million units of normal growth that one might expect based on population growth and normal wear and tear. Based on rising employment levels, I suspect housing starts will begin to improve in 2011 to around 750,000 units or more. It's a small increase compared to the past, but it would be triple the expansion we saw in 2010, making it a potential contributor to GDP growth in 2011. Expect even better in 2012.


December existing home sales are due on Thursday; those should look a little better based on the increase in pending home sales we have seen in the prior two months. In fact, the consensus forecast is for 8% growth in December to 4.8 million units, roughly the average of the increase in pending home sales the prior two months. If my forecast proves correct, existing home sales will be up four of the last five months and will have gone from a homebuyers' credit expiration bust level of 3.8 million units in July to 4.8 million units in December. While not directly affecting GDP, existing home sales provide some insight into long-term consumer confidence and--through the mechanism of brokerage commissions and increased furniture purchases--can provide a small lift to GDP.


Will Manufacturing Pick Up the Pace?

Two regional manufacturing reports are also due this week from the Philly Fed and the Empire State. Both metrics showed a nice pop last month, and I suspect that, barring weather issues, we should see modest improvement thus far in January. The auto industry, which was pretty much on hold production-wise for the last part of the year, looks to be accelerating in 2011.


This is an edited version. The article originated from Robert Johnson’s column at

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Robert Johnson, CFA  Robert Johnson, CFA, is director of economic analysis with Morningstar.

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