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March 31, 2005

Will GM Spoil Economic Growth?
by Chad Hudson

Consumer confidence slightly dropped in March according to the latest survey by the Conference Board. This came after four consecutive monthly increases that eclipsed the early months of 2002. Additionally, while consumer confidence is not near the levels reached in the late 1990s and 2000, it has rebounded to respectable levels. Plans to buy an auto dropped to the fourth lowest level since 1995. It is also noteworthy that income growth expectations have diminished. The percentage that expect incomes to rise over the next six months fell to 16.7%, the lowest level since July 2003. This was two percentage points higher than last month. Additionally, those that expect income to decline jumped two percentage points to 9.3%.

The condition of the labor market will become more clear following the February personal income report and the March nonfarm payroll report that will be release on Thursday and Friday respectively. Economists are expecting that 220,000 job were created in March. This would be lower than the 262,000 last month, but better than the average gain over the past year of 185,000. If recent surveys are an accurate indication of the labor market, it is likely the gain will be higher than economists predict. In the March non-manufacturing survey, the employment component jumped over seven points to a new high. The first quarter employment survey from Manpower revealed that employers were the most optimistic since the first quarter 2001. With investors already worried that the Fed is behind the curve, it's likely that a stronger than expected payroll report will not be well received.

This is usually the time that companies pre-announce earnings shortfalls. Besides a few in the auto sector, there have been relatively few pre-announcements lately. Most of the companies that have pre-announced that earnings would be lower than analysts forecasted happened when companies announced fourth quarter earnings. Of the 103 companies in the S&P 500 that have guided first quarter earnings lower, 84% did it in January or February. This lack of pre-announcements has helped earnings growth estimates drift this month from 7.2% to 7.8%. The most notable downward revisions have happened in the consumer discretionary sector. Of the ten worse performing stocks in the sector, five are auto related. We have discussed the woes plaguing the auto industry and now the low production volumes might be having a rippling effect.

The troubles with General Motors and Ford appear to be rippling through the manufacturing sector. This week, Parker Hannifin announced that its first quarter earnings will be $1.05 to $1.15 per share, about five to fifteen cents lower than previous guidance. Additionally, earnings for the full year will be $4.60 to $4.80 per share, up to 10% lower than the $4.75 to $5.15 range previously articulated. The company cited "greater-than-anticipated softening in the automotive market's slowdown in the mobile markets in our International Industrial segment; and ongoing inventory reductions." The reduction in inventory is likely another single that end demand is weaker than anticipated.

It is important to remember that at this point the problems that GM and Ford are having are mostly confined to those two companies. Even Chrysler is doing much better than its two domestic counterparts. However, the Japanese automakers are excelling. The three big Japanese automakers reported that their global production increased in February. Toyota's production increased by 12%, while Nissan and Honda increased production by 11% each.

Also this week, CarMax announced its earnings for the first-quarter might be lower than analysts expect. Besides higher advertising expense, the second-largest seller of used cars said that lending costs would likely rise faster than what the company could charge customers. Of course higher borrowing rates will be problematic for the rest of the economy. The housing market has become the marginal source of household net worth and discretionary spending.

General Motor's problems may have increased the link between the bond market and the stock market. Over the past couple days GM's stocks have become difficult to borrow. In fact, at least two brokers reported that they could not secure a borrow at all. The rise in hedge funds employing various types of arbitrage strategies has increased the amount of systemic stress. It's likely that in increase in GM's short interest is not only because short sellers betting the stock price will decline, but because holders of other GM securities needed to hedge positions and shorting the stock was the easiest way to gain the necessary exposure.

Chad Hudson
Mid-Week Analysis
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