Connecting the dots from the companies that have shown earnings results, we can see that profit growth has confounded expectations by slowing down dramatically.
I’m going to get right to the point — as Bob Dylan once said, “you don’t need a weatherman to know which way the wind blows.”
It wasn’t supposed to be this way, but higher energy and food prices and slowing wage growth has proven to be a lethal one-two punch. Add on top of this the new fiscal restraint promised in Washington and the potential for an end to quantitative easing in June, and you can see why the summer could be a bit rougher than we anticipated.
One major hedge fund economist that I deal with told me over the weekend that he has taken down his U.S. GDP forecast for 2011 to 2.5%, down from 3%, and downgraded his 2012 expectations too. “Fiscal rectitude is in until economic growth flags badly again,” he said. “Expect a fiscal drag through 2012 and beyond. Housing is stuck, employment growth will improve but remain subpar, consumption is being squeezed by the high price of gasoline, and the Obama Administration seems intent on a retrenchment in government spending after two years of stimulus. That’s not how they’re advertising it, but that will be the effect.”
Quoting Dylan again: “The pump don’t work ’cause the vandals took the handles.”
Everywhere you turn these days, you hear the same refrain. Two of my favorite mainstream economic analysts — Paul Ashworth at Capital Economics in Toronto, and Jan Hatzius at Goldman Sachs — both published reports on the subject last week, before the government released its initial first-quarter GDP estimate of 1.8%. Here are some selected excerpts (I have bolded key passages for emphasis):
Paul Ashworth, at Capital Economics: ”Every data release last week seemed to necessitate a further downward revision to our first-quarter GDP growth forecast. By the end of the week when the dust had finally settled, that estimate was down to only 1% at an annualized pace. A week earlier we still thought that growth might have been as high as 2.5%.
”Going into the first quarter, it appeared that the economy had everything going for it. Growth had picked up over the final few months of last year, the labor market was finally showing signs of a more meaningful improvement and the policymakers had just delivered another round of monetary and fiscal stimulus. The surge in food and energy prices changed everything, however. Based on the retail sales and consumer prices figures for March, it looks like real consumption increased by only 1.6% in the first quarter, less than half the 4% pace seen in the fourth quarter of last year. … The relatively modest 0.5% m/m increase in business inventories in February was another unpleasant surprise, largely due to a 0.4% m/m decline in retail inventories. Remember these are nominal figures and so, in a month when producer prices increased by 0.7% m/m, in real terms business inventories most probably declined. Our latest calculations suggest that inventories had a broadly neutral impact on first-quarter GDP growth.
”
”If first-quarter GDP growth really was as low as 1.0%, it means that output increased by less than employment, which we already know expanded by 1.2% at an annualized pace. This did happen in the second quarter of last year, but only because of the spike in temporary Census-related hiring.
”Even allowing for the very modest increase in average hours worked, that combination of growth rates points to an outright fall in productivity. The strength of productivity growth through the recession and the earlier stages of the recovery was one of the main driving forces behind the strong rebound in corporate profits. Now, however, it looks like firms are finding it much harder to generate additional efficiency gains. …
”The debate surrounding the need to rein in the Federal budget deficit is now in full swing, with the Republicans and the Obama administration offering competing visions. The former want to balance the budget principally through steep cuts to spending, whereas the latter would also boost revenues by increasing taxes for high-income earners.
“This talk of fiscal austerity is a marked change even from late last year when both sides were willing to sign up to the recent fiscal stimulus, which included not only further tax cuts, albeit temporary ones, but also the extension of some temporary spending programs. Only a few months later, both sides have agreed to cut spending by $38 billion over the remainder of the current fiscal year, which runs until the end of this September. …
“We will have to wait until after next year’s Presidential election to see which view ultimately wins out based on the election results. Nevertheless, it now looks like fiscal austerity will be the number one election campaign battle. …
. Other countries, particularly the UK and the peripheral euro-zone countries have already implemented their own austerity programs. Up to now at least, the debate surrounding the medium-term outlook in the U.S. has always played second fiddle to the need to boost economic growth in the near term.”
”Either way, this marks a turning point in the fiscal debate in the United States
“Clearly something has to give. Either taxes have to rise, future program beneficiaries will get less than they were promised or bondholders won’t get all their money back.”
* * *
Jan Hatzius and Andrew Tilton, at Goldman:
“With most of the news on first-quarter growth now in, the GDP ”bean count” looks even softer than it did a couple of weeks ago. The most recent disappointments have come on the export side, with trade now set to subtract significantly from growth in the quarter, and from inventories. Consequently, we are downgrading our real GDP growth estimate to 1.75% (annualized), from 2.2% previously (and from 3.5% not too long ago)….
“Other indicators still point to solid activity in Q1, but markets have become increasingly concerned about growth in the remainder of the year as well. A key reason for concern is the sharp rise in gasoline prices so far in 2011 — nearly 70 cents per gallon — which is siphoning off household income at a run rate equivalent to $100 billion per year. We are adjusting our Headline inflation forecasts over the remainder of 2011 to take the surge in fuel prices into account.
”Despite these higher fuel costs, consumer spending looks to have grown at a 2.5% pace in real terms in Q1, and — given strength towards the end of the quarter — is headed for a stronger pace in Q2. An important reason for the resilience: the payroll tax holiday has helped consumers to absorb the increase in gasoline prices over the past few months. (Put another way, higher oil prices have fully offset the impact of the payroll tax cut.)
”Going forward, our forecasted reacceleration in spending growth still looks possible, but will require a fortuitous combination of circumstances — a modest further pickup in the labor market, gasoline price relief, and a benign asset price environment that encourages consumers to gradually reduce saving.”
Now here is my bottom line.
Higher energy prices and higher food prices may not play a role in measuring core inflation, but they do play a role in how businesses and individuals spend their money. And with wage growth reversing and employment growth weakening at a time when the government is shifting from a focus on fiscal stimulus to a focus on fiscal contraction, a perfect storm is brewing that could upset expectations for improved corporate earnings in the second quarter.
This could be a problem for stocks, particularly if the Fed is concerned enough about inflation to quell speculation about the potential for a third round of quantitative easing after June.
Unless some executives start to sound a lot more optimistic than they have been, the stock market could be in for some rough sledding in May as investors reassess the multiples that they are willing to pay for stocks that could be near peak earnings.
For more guidance like this, check out Markman’s daily trading service, Trader’s Advantage, or his long-term investment service, Strategic Advantage
