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August 11, 2005

4.25% by year-end?
by Chad Hudson

UNEDITED!

On Tuesday, the Federal Reserve raised rates by 25 basis points for the tenth consecutive time to 3.5%. The Fed watchers noted that there were two major changes in its communique. First, the Fed said that, "aggregate spending, despite high energy prices, appears to have strengthened since last winter." Previously, the Fed said that "expansion remains firm." The other significant change was adding, "Core inflation has been relatively low in recent months." It would appear that the Fed does not think that higher energy prices are restraining consumer spending. Additionally, the some economists have argued that higher energy prices acts like a rate by curbing spending, thus the Fed does not need to raise rates as high as otherwise would without higher energy prices. It appears that the Fed does not agree with this reasoning.

Fed fund futures are pricing in the possibility of three more increases this year. Fed fund futures are now pricing in the possibility of fed funds reaching 4.25% by the end of the year. Traders are now forecasting another 25 basis points in the next two meetings, pausing in December, than raising rate to 4.25% in February 2006. This week, Goldman Sachs raised its target for mid-2006 fed funds to 5% from 4.5%.

In conjunction with increasing estimates for when the Fed will stop raising rates, economists are also boosting their forecasts for economic growth. According to the monthly survey conducted by Bloomberg, the median forecast for third quarter GDP growth has jumped to 4.1% from 3.5% last month. This would be the fastest pace of growth since the first quarter of 2004. Estimates for fourth quarter growth were also revised higher by 10 basis points to 3.5%.

Stronger economic growth has benefited corporate earnings. About 90% of the S&P 500 has reported second quarter earnings; retailers are the only major group left to report. Second quarter earnings growth is now estimated to be 11.5%, with about 70% of companies exceeding analysts' estimates. This marks the eighth consecutive quarter of double-digit earnings growth. According to First Call, there have been only three other periods that earnings have increased by double-digits for eight quarters or more since 1950. Analysts expect earnings to increase by double-digits for the third and fourth quarters as well.

Each of the ten S&P sectors has reported earnings growth higher than was expected at the beginning of the July, but three sectors have reported earnings growth lower than anticipated at the beginning of the quarter. Consumer discretionary stocks and financial stocks have underperformed the expectations set at the beginning of the quarter the most. Earnings for consumer discretionary companies declined 3% in the second quarter compared to growing 2% expected on April 1. The auto and auto parts companies account for the decline and excluding the six automotive related companies, earnings for the consumer discretionary sector would have been up double-digits. The flattening yield curve caused financial stocks to post 2% earnings growth instead of 7% growth expected at the beginning of the quarter. Not surprising energy and materials companies have posted the strongest earnings growth. The energy sector grew earnings by 41% in the second quarter and earnings in the materials sector were up 26% from last year.

Federated and May Department Stores were two of the first retailers to report second quarter earnings. These two department stores offer an example of what is happening in retail. High-end retailers have done much over the past couple of years. Middle-end retailers, especially department stores, have not performed nearly as well. First it should be noted that Federated is acquiring May. The deal is expected to close during the third quarter. Federated, is a more upscale retailer and is the operator of Bloomingdales and Macy's. May is middle-end and operates Foley's and Lord & Taylor among others. Federated reported that earnings increased 14%. Same store sales increased 1.1% and the company expects same store sales to increase 3% during the second half of the year. At May, earnings fell 19% excluding charges related to the acquisition. Its same store sales fell 1.6%. Gross margins at Federated expanded to 41.3% from 41.0% last year. All of this gain, plus a little more was able to drop to operating income, even with same store sales increasing only 1.1%. Operating margin increased 32 basis points to 8.03% causing operating profit to increase 18.8% on a 1.2% increase in revenue. Gross margins at May fell 164 basis points to 28.5%, about 100 basis points was due to "proprietary markdowns" to clear out private label inventory prior to the acquisition. This was the lowest gross margin in more than 10 years. The middle-end department stores have come under significant pressure over the past couple of years. Federated hopes to increase the amount of private label merchandise at May to boost its margins. With all the competition that has infiltrated the middle-end retailers over the past several years, it is likely to be more challenging for Federated to turn operations around at May and analysts are

Last week, Freddie Mac released a report detailing its mortgage refinance activity for the second quarter. The report confirms that the hot housing market has helped boost consumer spending. Most homeowners that refinanced during the second quarter did so to cash-out equity rather than lower their monthly payment. Of the mortgages that were refinanced during the second quarter, 74% resulted in a higher loan balance of at least 5%. The average interest rate declined by 67 basis points. The report gave further evidence that housing prices have accelerated recently. It said that the median appreciation for homes that were refinanced was 23% since the original mortgage was written. It also said that the average age was 2.6 years. Since Freddie Mac has provided this data quarter for several years, we can see that the 8.3% annualized appreciation for the home refinanced during the second quarter experienced that highest annualized appreciation since at least 1996. The average annualized increase has been only 4.4% over the past nine years. Freddie Mac estimates that homeowners cashed out $102 billion worth of equity during the first-half of the year. This is expected to decline to $60 billion for the second-half and only $69 billion for 2006.

Speaking of the GSEs, on Wednesday, Fannie Mae disclosed that it will not have its 2000-2004 financials ready until the second-half of 2006. Daniel Mudd, CEO of Fannie Mae, said it would take six to eight million labor hours to finish the restatement. Maybe that explains the better than expected employment number.

Chad Hudson
Mid-Week Analysis
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