The US economy continues to defy the predictions of economists of all stripes by neither collapsing nor breaking out on the upside. Instead, after an initial burst at the start of this recovery driven by inventory restocking, inflation-adjusted GDP growth seems to have settled into a less-than-satisfying growth rate of 1.5% to 2.0%. About half that growth is coming from non-US markets that have driven exports up to 14% of GDP, an-all time record.
In stark contrast to the weakness in Europe and the United States, growth in emerging markets remains robust. Companies serving developing markets are continuing to benefit from that growth, even as US results remain lackluster. In fact, large, multinational companies continue to report decent earnings, again largely based on strong overseas sales. Meanwhile, small businesses, which generally have less exposure to foreign markets, continue to struggle.
Uncertainty Slows Spending
Another big theme among our analyst teams is how persistent uncertainty continues to weigh both on consumers and businesses. The unknown effects and resolution of the European debt situation have been particularly troubling to markets. One day it seems things are all resolved and just a few weeks later, it is back in the news again. The US budget crisis in August definitely didn't help, either. That smoldering fire could burst into the flames again later this year if the bipartisan budget committee can't come up with enough cuts.
Uncertainty Causes Investors to Bid Up Safe Stocks
Apparently uncertainty has carried over to investors, who are now bidding up the more defensive portion of our stock investing universe and seeking stocks that provide income in addition to capital gains. While Morningstar's overall coverage list is selling at a 14% discount to our fair value estimates, the consumer defensive, real estate, and utility sectors are selling at very close to their fair values. Meanwhile riskier sectors with less good news, including financials, basic materials, and energy, are selling at bigger discounts than our overall average.
Corporations Have the Cash, But Are Afraid to Spend It
Although corporate spending is up, I believe it could be up a lot more if businesses had the certainty and the confidence to invest. Corporate margins are near all-time highs, and cash balances remain well above normal levels. The Federal Reserve recently reported that corporate cash balances reached a new high at $2.05 trillion in the June quarter. That compares to $1.96 trillion in the first quarter and $1.4 trillion in the middle of the recession in 2008. That cash continues to show up in increased merger-and-acquisition activity highlighted by some of our teams in their quarter-end reports. Borrowing money at exceptionally low rates and buying back stock seems to be another trend that is accelerating, according to Morningstar's analyst team.
Regulation Is Stifling the Economy, Too
Another theme I am hearing across our teams is the dramatic effects of regulation. The financial sector is being particularly hard hit with the new Dodd-Frank legislation that was more than 2,300 pages long and created more than 500 new regulatory regimes. While some reform is indeed necessary and overdue, the piece of legislation appears to have gone a little overboard. Unfortunately, many banks have stepped up their layoffs as the new legislation cuts into corporate profitability. Investors realize this, too, as the financial sector is now the most undervalued in our stock universe.
Zealous bank examiners and appraisers are not helping the housing market, either. After years of housing contract signings closely correlating with final home closing transactions, the relationship between pending home and final closed sales has broken down. In truth, we had a couple of months where pending sales were up and closings were down. Failure of homes to appraise and tight bank lending rules caused a midteens contract cancellation rate versus the more typical 8%-10% range, resulting in the disconnect in the data. Again, processes were certainly too loose before the crisis, but now those same regulators and bank examiners are going overboard in the other direction.
Our health-care team also reports that many device companies are being affected by increased regulation and proposed new rules this summer, though the team hopes that greater clarity on these new rules will come this fall, breaking some of the initial bottlenecks. Again these stocks are near the bottom of our sector valuations.
The National Labor Relations Board has also taken a more aggressive stand against companies. For example, Boeing is being investigated for moving some production of its 787 to South Carolina, a right to work state. The board also revised labor organizing rules that now allow groups as small as 10 people to form a union. Theoretically smaller groups can organize more easily, putting businesses at a disadvantage. And it is more likely that union organizers could easily find a small group of disgruntled employees.
On the other side of regulatory tightening is the oil industry, which is now coming out of an almost a complete lockdown last year as a result of the Gulf spill. Now as more drilling is permitted, employment growth in the mining and drilling sector is expanding at a healthy clip.
Consumers Continue to Push Ahead Slowly, Cautiously, and Consistently
Through all of the uncertainty, the consumer has held up better than many would have suspected. Same-store retail sales, as reported by the International Council of Shopping Centers, have continued to increase at a 3%-5% level for the last year without the tremendous volatility seen in other parts of the economy. Through earthquakes, hurricanes, and budget crises, the consumer has not given up. Overall, consumers have accounted for three fifths of the economic growth during this recovery.
However, the consumer isn't going crazy on the upside, either. Frankly, consumers can't hike spending much, as inflation-adjusted, aftertax income to the consumer has begun to stall out.
I would be a little more frightened about the inflation-adjusted income numbers if I wasn't fairly confident that inflation was on a downward trend from here. A slower world economy and a resolution of the Libyan situation should help drive oil prices, the key driver of high inflation, lower in the months ahead. Food prices should also begin to move lower as crops are harvested and some of the dismal weather conditions around the world abate. Resumption of shipments of Japanese automakers should also help drive auto prices lower in the months ahead. Autos were a surprising source of inflation earlier in the year with price hikes exceeding 1% for three months in a row.
Consumer Vigilantes May Keep a Lid on Prices
I think it is also interesting to watch how often and consistently consumers have been punishing categories and companies that raise prices too fast. I have noted in many columns that gasoline demand in the US is down for three quarters in a row and corresponds closely with the acceleration in gas prices. Now some other categories are showing the same phenomena--for example, autos and apparel.
As auto prices accelerated this spring (at least partially a result of Japanese supply-chain issues), auto sales collapsed. Then as prices stabilized, sales rebounded. The news in apparel is the same. As price fell this winter, apparel sales boomed. Then following months of price hikes, many related to the price of cotton, apparel sales not only slowed, but actually fell.
Even on a company basis, consumers clobbered Netflix after their recent pricing change was implemented. And our consumer team is blaming some of August's dismal restaurant sales on recently announced price increases.
I believe that these consumer vigilantes will help keep a lid on prices in the months ahead. However, I am concerned about commodities where there is a world market. Poor US demand has done little to keep a lid on oil prices as demand continues to accelerate in Asian markets.
Rich Man, Poor Man Dynamics Continue
We continue to hear about bifurcation of the economy, too, with the low-end consumers being punished even as the high end continues to boom. Symbolic of the situation is high-end retailer Hermes, which reported a shortage of purses, and Saks intentionally moving its price points up to entice more high-end customers. Even the recent sag in the stock market and falling gasoline prices (which disproportionately benefit low-end consumers) haven't done much to change the disparity of performance of these two groups.
Besides Consumers, Exports Are the Biggest Driver of the Economy
Through eight quarters of the current recovery, exports have grown by 2.6% overall, contributing more than half of total GDP growth of 5.0%. Exports now account for 13.9% of GDP, their highest level in history.
A weak dollar, a revival of the manufacturing sector, strong capital goods sales in emerging markets, and powerful agricultural sales are behind this trend. A newly resuscitated chemicals and plastics industry have been a big help, too, driven by low natural gas prices. Interestingly export growth year to date has been driven by increases in shipments to North America and assorted countries labeled as "other" in official government reports. Shipments to China and Europe have been basically flat in 2011.
Robert Johnson, CFA, is director of economic analysis with Morningstar.
