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April 20, 2006

Near the End?
by Chad Hudson

This week the Federal Reserve released the minutes of the March FOMC meeting. The focus was on the comment that "Most members thought that the end of the tightening process was likely to be near, and some expressed concerns about the dangers of tightening too much." The minutes also said that, "Several members were concerned that market participants might not fully appreciate the extent to which future policy action will depend on incoming economic data." Since the meeting, the economic data suggests that economic activity has accelerated along with increased inflation pressure and increased resource utilization.

Industrial production rose 3.6% from last year. This was the fastest growth since June 2005. Additionally, capacity utilization increased to 81.3%, the highest since September 2000. The Federal Reserve has expressed concern over resource utilization. Capacity utilization is at a five year high, but several industries are approaching the capacity used during the mid-1990s. The machinery sector is running at 83.2% of capacity. The highest it has been over the past fifteen years was 87% in the mid-1990s and was as low as 63.4% in 2001. Electrical, apparel and rubber and plastic manufacturing are also near the peaks reached ten years ago. And all are above the levels reached in 2000. Much of this industrial production is not only for the expanding US economy, but is being exported to the rest of the world as economic growth has strengthened, especially in Asia.

In March, producer prices rose 0.5%, with the core rising 0.1%. On a year-over-year basis, prices rose 3.5% and 1.7% respectively. Producer prices have been rising faster than consumer prices since the beginning of 2003. This has narrowed during the past two months as producer prices have increased at a much slower pace than during the second half of 2005. Unfortunately, much of the analysis stops there without fully acknowledging that the huge price increases that happened last year have stuck and prices have not retreated at all. Producer prices will likely increase as several commodities have soared in April. Oil has increased over 8% this month and has increased a total of 19% since March 20. Natural gas is up 14% in April. Several of the industrial metals are up over 20% this month. Copper is up 23% this month, and is up 40% since the end of February. Aluminum is a laggard, up a paltry 9% this month. Nickel has jumped 21% in April and zinc is up 36% since the begging of March.

Consumer prices rose 0.4% in March and excluding food and energy, the CPI rose 0.3%. Compared to last year, consumer prices were 3.4% higher with the core rate up 2.1%. Over the past several years, the soaring housing prices have not been adequately reflected in the Consumer Price Index. This might be starting to change. Owners' equivalent rent increased 0.4% in March. This was the largest month-over-month gain since November 2001. Compared to last year, the gain was 2.8% and this was the largest increase since March 2003. Rent of primary residence was 3.2% highest since November last year, which ties the highest year-over-year increase since November 2002.

There is mounting evidence that the housing market has softened considerably. The National Association of Home Builders index measuring confidence dropped four points to 50 in April, lowest since November 2001. Traffic fell one point to 39.

Housing starts dropped from 2.126 million units to 1.96 million in March. This was the slowest pace of starts since last March. Permits also fell in March to the lowest level in a year. Most of the drop was due to a decline in single family starts, which dropped 1.6%. This was the largest monthly drop since September 2002 and compared to last year, starts of single family homes were 6.9% higher, the slowest year-over-year increase since July 2003. All regions of the country had lower starts except for the Northeast, which was flat. The Midwest has been the weakest part of the country. The number of starts in the Midwest fell 1.2% in March and was the second consecutive sequential decline. On a year-over-year basis, starts in the Midwest were 3.8% lower than last year, a trend that started last March.

D.R. Horton reported earnings that matched Wall Street estimates. The largest homebuilder reported earnings that were 21% higher than last year. Revenues were stronger than anticipated, but margins were weaker than analysts modeled for the quarter. Analysts attributed this combination to DR Horton's higher use of incentives. New orders increased 10%. Geographically, Texas had the highest sales growth, up 26% and Florida and Arizona were weakest, both down 8%. The company said that investors have already diminished their presence in the hot markets, but still hold properties. Additionally, higher interest rates and higher than normal incentives are causing cancellations to run higher than the previous few years. The company expects gross margins to continue downward and said gross margins are likely to be between 24% and 25%. This compares to the 25.3% gross margin the company reported for the first quarter.

Companies have been exceeding analysts' estimates for first quarter earnings. There have been just over 100 companies in the S&P 500 that have reported first quarter earnings. Almost 70% have earned more than Wall Street was anticipating. Commentary from the conference calls has reinforced the economic data that has indicated the economy has strengthened dramatically during the first quarter, especially the industrial sector.

Eaton reported a 14% increase in earning per share for the first quarter that was about 6% higher then estimates. Sales were up 14%, acquisitions accounted for about 6% of the increase, but it was able to outgrow its end markets, which grew 7%. Foreign exchange accounted for a 1% decline in revenue. Strength in non-residential construction was cited as a key driver to Eaton's strength. It estimated that non-residential construction was up 4% in the quarter and expects non-residential construction to be up 6% for the year. This compares to a forecasted drop of 8% in residential construction this year. Its truck business was stronger than it anticipated, but is preparing for a 40% drop in orders next year. New emissions standards go into effect next year and trucking companies have maxed out production schedules this year in order to avoid buying the new trucks next year. The new engines are less fuel efficient and reliability is also questioned. Due to the markets Eaton serves, it usually has good insight on the manufacturing sector and the economy in general. At the beginning of the year the company thought its end markets would increase by 3%. It now is forecasting its markets to increase by 4% this year. It expects the Federal Reserve to increase rates at least two more times and possibly three times this year. This will cause GDP growth to slow during the second half of the year. The company has also seen growth in Europe, but said it was more due to exports out of Europe than actual European growth.

The release of the minutes from the March FOMC meeting caused investors to reassess how high the Federal Reserve will raise rates. Prior to the release, fed fund futures were pricing in an almost certainty that rates would reach 5.25% by the October meeting. Now it is about a 60% chance that it happens at all. Housing is about the only sector of the economy that has started to slow, but remains at a very high level of activity. While housing started dropped in March, it was higher than any month prior to September 2003 in the past fifteen years. Consumers have shown signs of slowing, but it is likely that April results will reveal that consumer spending has remained buoyant. This week, Target said that April same store sales will rise 10%.

Chad Hudson
Mid-Week Analysis
PrudentBear.com

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