Weekly Update: Perfect storm
The colliding storms that were the subject of the movie played out in the real world with devastating consequences this past week when Hurricane Sandy met up with a cold front. Even though only a Category 1, Sandy likely will end up being the fourth most-expensive hurricane in the last 50 years—projected economic damage ranges from $30 billion to $50 billion. Some say the rebuild eventually will be a tremendous boost to regional growth, but other studies say such benefits tend to be significantly overstated (more below). The markets were forced to close due to weather on consecutive days for the first time since the Blizzard of 1888, just as a disappointing earnings season was winding down. And the presidential campaigns took mini-breaks during the critical final week. By freezing the race for a couple of days, Sandy may have hurt Gov. Romney because he had momentum and was leading among independents in most national and swing states, something that is not consistent with losing. But with Obama trailing in most national polls, Sandy also could have hurt Obama because it gave him less time to turn it around even if he appeared presidential. In other words, Sandy’s impact on the election may prove to be a wash.
Since the mid-1970s, equity markets have proven indifferent to political outcomes, with median total returns all but identical whether the White House is Republican or Democrat. U.S. presidential cycles, which always have started between the second and eighth of November since 1928, have tended to produce considerably lower equity returns in the first two years vs. the last two years of the cycle, with historical averages of 3% to 4% vs. 10% to 12%. This year, the presence of the fiscal cliff makes the 2012 election one of only a few contests in which such a large fiscal policy shift will be on the table so soon after an election takes place. But even with prospects of policy land mines on the horizon, the market tends to discount things freely available to read in the Wall Street Journal. In my speeches around the country, I ask audiences to consider what is already priced into the market. One priced-in outcome is a substantial rebound in profits in the fourth quarter, with the current consensus projecting 10% year-over-year earnings-per-share (EPS) growth in the current quarter, up from an estimated 3% decline in the third quarter. Rising estimates aren’t just a fourth-quarter story. Consensus estimates for each quarter of 2013 are in the double digits, and the calendar year 2013 consensus EPS estimate is $115, up 13% from the 2012 estimate.
Historically, it has been rare for earnings to post negative growth for just one quarter. Since 1953, earnings growth has turned negative 18 times—all but three marked periods of sustained negative-to-flat EPS growth (the average is 3.4 quarters before a return to positive growth). But while margins could decline in coming quarters, the drop is unlikely to be as significant as some suggest—historical evidence suggests secular shifts in profit margin trends tend to last decades. In addition, any corporate tax reform is likely to set tax rates lower based on current proposals from both sides of the aisle. This tax-and-interest-rate environment is the main reason profit margins can remain elevated on an historical basis, even if they shrink somewhat. And declining margins do not always portend stock weakness. In fact, the average S&P 500 return in all years in which profit margins narrowed was nearly 8%. One of my favorite books is “Endurance,” which chronicles man’s attempt to fight Mother Nature. My second favorite book is “The Worst Journey in the World,” more of the same. A few years back, someone decided it was not politically correct to name hurricanes exclusively with female names. Whatever, Sandy is a woman, I’m sure of it.
Positives
The jobs report was strong/weak depending on the channel you watched This morning’s better-than-expected jobs report was still consistent with just 2% growth, and other economic gauges out this week pointed to modest but still subpar growth. The ISM manufacturing index rose to 51.7, a bit above of consensus and the second consecutive reading above 50, as new orders rose to their highest reading since May. Construction spending rose in September and was revised upward for August, pushing it above government estimates and indicating third-quarter GDP may be revised up from its initially estimated 2% increase. And the Conference Board’s consumer confidence gauge rose in October to its highest level since February 2008, with both the present situation and expectations components improving.
Housing contributing to GDP Case Shiller's 20-city home-price index rose a seventh consecutive month in August, with 19 regions posting gains led by Atlanta and Phoenix. That price gains are becoming widespread is an encouraging sign that the housing sector is on a sustained uptrend, across both activity and prices. After being a drag on GDP every quarter for several years beginning in 2006, housing has added 1.2 percentage points to GDP growth over the past four quarters.
Spending up some September personal consumption expenditures rose by the most since August 2009, and for a third straight month, with nondurables having their biggest two-month advance since September 2005. October vehicle sales slipped from September but still rose 7% year-over-year—dealers blamed Hurricane Sandy for cutting off sales the final days of the month. Overall, the improvement indicates the consumer side of the economy is doing better than the business side, as the former seems to be less concerned about the fiscal cliff (Why, do you suppose?).
Negatives
Fear the cliff Real disposable income has fallen at a 0.8% annual rate since June and the savings rate is down to 3.3%, indicating the consumer has virtually no cushion to absorb 2013's scheduled tax hikes if the fiscal cliff isn’t addressed. Even if the expiration of Bush tax cuts on households earning over $250,000 were the only piece of the cliff to hit, it would shave 1.4 percentage points off GDP in an economy that’s barely growing (more below). New IMF research suggests fiscal multipliers may be larger when monetary policy is at or near the zero-rate stage, as is the case now. This means instead of a more traditional multiplier (for every dollar cut, the economy loses 50 cents), fiscal multipliers may be more like 0.9 to 1.7, making austerity moves such as the cliff all the more worrisome.
Is a recession looming? Nominal GDP grew at only 2.8% in the first half of the year, a level always associated with recessions since 1960—nominal GDP growth below 4% historically has been considered recession-like. Strategas Research also notes corporate guidance during the third-quarter season has been its most negative in 11 years. A recession is one outcome clearly not priced into the markets.
Don’t expect Sandy to help Longer-term GDP growth is a compounding process that builds on the capital base using labor and innovation. Unless the rebuilding process adds to productivity by building substantially better assets, hurricanes hurt growth due to the asset damage and extra debt taken on to rebuild. Renaissance Macro cites French economist Frederic Bastiat’s “broken window’’ parable, in which a shopkeeper spends six francs to replace a window broken by his son. The glazier who replaces the window may be happy because he gets six francs, but what isn’t seen is that the shopkeeper who spent his money for the repair may otherwise have spent it elsewhere, potentially on a more productive use. The moral: breaking and replacing windows doesn’t “grow” the economy.
What else
The year of ‘once-in-a-lifetime’ 2012 has been one of the most volatile years on record for global weather. Sandy is being called a once-in-a-lifetime event by meteorologists. The U.S. has witnessed one of the hottest years on record and some of the most widespread droughts ever seen. Parts of central and Eastern Europe also saw record summer temperatures. The UK went from one of the driest periods on record to the wettest summer since records began. India and the Philippines also suffered one of the wettest years recorded. Meanwhile, the Arctic sea ice melted to its lowest on record this summer. There is compelling evidence suggesting the climate is becoming more volatile/extreme than in the past.
Fuel for thought Yardeni Research shares this note from an account in Geneva: “We are baffled by the phenomenon of the U.S. constantly losing power whenever there is a storm. Why aren’t U.S. power lines underground? Nobody here in Switzerland has seen a power line above ground since their childhood—they’ve all been placed underground, so they are safe from the elements. And there are no power losses in the country ... no matter how heavy a snowstorm or a windstorm!”
And a final thought on the election King Securities forwards this quote from French philosopher Joseph de Maistre: “In a democracy, people get the leaders they deserve.”
