Is Iraq Slowing Down the Economy?
Today, the Federal Reserve Board left interest rates unchanged at 1.25%, surprising only two out of the 88 economists surveyed by Bloomberg. The Fed again cited geopolitical risks as the primary reason for the weakness:
"Oil price premiums and other aspects of geopolitical risks have reportedly fostered continued restraint on spending and hiring by businesses. However, the Committee believes that as those risks lift, as most analysts expect, the accommodative stance of monetary policy, coupled with ongoing growth in productivity, will provide support to an improving economic climate over time."
It is interesting to note that the Fed seemed to hedge itself by including, "reportedly" and the phrase, "as most analysts expect." The idea that a looming war in Iraq is causing businesses and consumers to restrain spending seems puzzling. Memories of the 1990s Persian Gulf War are fresh enough in everyone's mind, and very few expect another war with Iraq taking much longer. In fact, just a few weeks ago on The News with Brian Williams on MSNB, three military experts that all agreed that the war would be over in about 20 days.
A much more plausible explanation behind the slowdown in business and consumer spending is the country's underlying economic condition. Businesses are faced with excess capacity and declining end-demand. Consumers are realizing the economy is weak and the labor market is not turning around soon. Plus, consumers have already taken advantage of low interest rates, through home refinancing and zero-percent auto financing, to boost their standard of living. As has been discussed, these financed purchases likely pulled sales forward, and we are now staring to enter the period of time that purchases were pulled from.
I continue to be amazed at the influence refinancing activity has played over the past two years, and especially the past six months. The Mortgage Bankers Association Refinance Index never got over 2,000 until the 1998 boom. It went has high as 1,600 and 1,800 a few times in 1992 and 1993. The first two weeks in 1998, the refinance index boomed to 3116 from 583, then drifted back down before soaring to 4,389 in October. This activity was short lived as the index ended 1998 at 1,441. During 1998, the refinance index was above 2,000 for only 13 weeks. This compares to the current boom, which has seen the index above 2,000 every week since July 5, 2002. Moreover, the weekly index has only been below 1,000 twice since 2001 started. If consumer spending has been showing cracks given the hyperactive refinancing activity, the underlying strength of consumer spending is weaker than current economic data suggests.
Consumer confidence fell to 79.0, a nine-year low in January according to the latest survey by the Conference Board. This is even more notable since consumers are getting more pessimistic regarding the future. The present situation component rose 5.8 points, while the expectations fell 6.7 points. Only 14.3% of respondents expects there to be more jobs in six months and 20.9% expect there to be fewer. Along with measuring consumer confidence, the Conference Board also inquires about future purchasing plans. The survey asks respondents if they plan on purchasing a home, auto or major appliance within the next six months. For simplicity in discussion, I've added the three components together instead of discussion each one separately. Currently, 37.9% of consumers plan on purchasing a home (3.4%), car (6.7%), or appliance (27.8%). This is the second lowest reading this year, behind 36.7% in September. It is the longest stretch since January 1997. Since January 1997, there have only been 23 such months, out of 71 months. Just for some prospective the previous 71 months contained 58 months where consumers were not planning on making a large purchase. Since 1990, the lowest it has reached was 27.7 in July 1993. Most economists continue to expect consumers to maintain or just slightly slow their consumption. Even by returning to normal spending habits, the severity of the consumer slowdown could surprise most economists.
Going back to the notion that Iraq is the source of all economic problems. Chuck Hill, Director of Research at First Call, issued his weekly research note last week that included a differing point:
"Investors have been fixated on the Iraq situation which has been increasingly dominating the news. Many are blaming the uncertainty over the Iraq situation for the reluctance of business to spend. Some are saying the fiscal stimulus plan should add more tax breaks to incentivise business to increase capital spending. Baloney on both.
THE OVERIDING PROBLEM REMAINS THE EXCESS CAPACITY BROUGHT ON BY THE CAPITAL SPENDING BINGE THAT WAS THE ROOT CAUSE OF THE RECESSION."
There is also a lot of discussion on the number of companies beating fourth quarter earnings estimates. Not surprisingly, these estimates have come down significantly since last summer, when the second-half recovery was still a pipedream. At the beginning of July, fourth quarter earnings were expected to increase 28%. It looks like earnings growth will now come in around the 11% to 12% range. It is important to remember that last year's results were very poor, declining 21.5%. Comparisons start to get tougher for the first quarter and will be versus positive growth in the second quarter.
While 11% to 12% earnings growth is sounds respectable, this is off a very low comparison and earnings continue to be driven by cost cutting instead of top-line growth. According to First Call, revenues for the S&P 500 companies will increase by only 5.3% during the fourth quarter. More importantly, companies are guiding earnings for the first and second quarter of 2003 lower. First quarter earnings have already come down from 17.4% in October to 10% now. This will be against earnings falling by 11.5% in 2002. Second quarter growth is already sequentially lower than first quarter, 9.4%. This would be against an increase on 1.4% in 2002.
I was hoping to be able to go through a few earnings announcements and conduct a quick "red-flag" analysis along with coming up with ten items to watch for with examples. Unfortunately, a stomach virus played round robin on my family and made my weekend much less productive. I'll get to some company specific earnings next week. So I'll leave open the request line. If you hold or are interested in a quarterly earnings analysis on a particular company please email me with your request.