At Your Service

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A while back I penned an article that pointed out the US was experiencing the weakest service sector recovery cycle since the 1940’s at least. Important why? Simple enough, the bulk of modern day US GDP is driven by the service sector, especially the domestically focused components of GDP. Time for a quick check in. And why now? Because in the 3Q GDP numbers that hit the tape a few weeks back, the character of US goods exports took a bit of a dark turn. Very important in that goods exports in the current cycle have been accounting for a very meaningful portion of total US GDP, easily 50% greater than the contribution of US business spending (equipment and software), and more than four times greater than the contribution of the “recovery” in autos or housing on reported US GDP. Government spending and exports are the two workhorses of the current cycle.

The chart below is a look at the year over year change in nominal US exports since the late 1960’s. The key fingerprint character point is that the rate of change in US exports has fallen meaningfully either during or in front of each “official” US recession of the last four decades. We’re seeing a meaningful rate of change decline again now.

us good exports 1968 to 2012

Although this is just my personal opinion, 3Q corporate earnings so far sure seem to display one very consistent theme – global economic slowdown, primarily related to Europe and Asia (China). Even formerly earnings impenetrable Apple showed us very disappointing European sales comps. The key question for equity positioning ahead now becomes, are we at the very beginning of the fallout economic impact of European and Asian economies on corporate earnings trajectory? Without question economic slowing in Europe and Asia impact US multinational and well as global multinational corporate earnings with a lag. Slowing in these geographic areas began long ago, but the pronounced influence on corporate results has been most visible with the 3Q numbers. You’ll remember that in the 2006-2008 period where the US was laboring under the impact of deteriorating domestic credit markets, the Street believed China and Europe would decouple. That belief proved ephemeral at best. We once again heard the decoupling cry regarding the US in the current cycle as European and Asian economies showed us slowing long ago. Is decoupling again a pipe dream? 3Q numbers sure seem to be telling us as much.

Just what can we expect ahead? Are we headed for recession, and if so, what will it look like? The recession question remains an open topic. As mentioned, in the current cycle the US service sector has shown us the weakest recovery in a half century at least. The quarter over quarter and year over year numbers below are crystal clear in terms of message.

real gdp change service sector 1948 to 2012

I personally believe the very shallow service sector recovery is directly related to the fact that small businesses in the US never really fully participated in the total cycle economic recovery to date. I will not drag you through charts or commentary as I’ve discussed this theme many a time over the past three years using the “tale of two economies” characterization. In the current cycle of 2009 to present, the very large US companies have been the major beneficiary of meaningful foreign stimulus that translated into capital spending. They have also been given the gift of once in a lifetime financing costs (in the capital markets) as provided by the Fed’s interest rate suppression activities. Finally, they have been able to collectively achieve record profit margins in large part via the reduction of primarily US labor related costs. Small businesses in the US weren’t even on the same playing field in terms of total economic benefit.

But as per the character of 3Q earnings up to this point, it’s beginning to appear as if the shoe is now on the other foot, if you will. With record high profit margins, corporations will now feel bottom line pressure with any type of globally or domestically generated top line pressure in the absence of being able to meaningfully reduce labor costs even further. We saw DuPont announce 1,500 heads to go with their disappointing 3Q numbers, but that’s a drop in the bucket in terms of total DuPont headcount. Let’s put it this way in terms of US labor market redundancy and excess of the moment, this is not 2007-2008. There will be no repeat performance of headcount reduction.

IF the US is to head near recession at all, and completely exclusive of any further dark US fiscal cliff resolution fallout on the economy, it’s the large companies that will take us there. It’s not that smaller US companies would be free of contractionary impact, but given their relative lack of recovery in the current cycle, there are no “heights” from which to fall. For years I’ve watched the “real final sales to domestic purchaser” data in each GDP report for one very simple reason – it excludes the influence of changes in US inventories and it also excludes exports. In many senses, it’s a look at the domestic economy only. For now, this is where we stand relative to historical context.

us real final sales to domestic purchases 1948 to 2012

Although there are no hard and fast guarantees in this wonderful world, every time we’ve seen current rate of change activity levels historically, the US has been in or quite near recession. Look, I’m not interested in the official recession or otherwise debate. That’s for posturing. THE issue of the moment is the forward trajectory of corporate earnings set against what sure appears a changing global and US macro backdrop, and importantly set against very high 2013 corporate earnings expectations of the moment.

Just what will have more impact on investor decision making ahead? The reality of corporate earnings character, or the initiation and perhaps acceleration of QE3? Remember, when QE1 was initiated, the rate of change in US corporate earnings was screaming higher, courtesy of lay up comps generated in the darkness of 2008. Corporate earnings were also growing in high single digits when QE2 took center stage. But with perhaps the most open ended QE so far, we now find ourselves in a very slow growth macro environment and as of now, the first quarter of negative year over year earnings comps since 2009. For those of you technically oriented, you know that technical divergences can often contain very important “messages”. Does that also hold true on the fundamental side of the equation? The answer lies dead ahead.

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About Brian Pretti CFA