When the wonderful CFO’s of this world speak, it usually pays to listen. And they have spoken, at least as per the 1Q Duke/CFO survey that hit the tape last Thursday. Let’s listen in very quickly as there are a number of what we believe to be important messages. Right to the point, the level of CFO optimism in 1Q hit a level very near the most recent peak seen in 3Q 2009, the first quarter after the supposed Great Recession. Please remember that when CFO optimism spiked up in early 2009, a lot of folks were pretty darn convinced that the world was still coming to an end. Not the CFO’s, and they were absolutely correct. So fast forward to the present and there are a good number of folks, including myself, questioning just what the heck is going to happen to the real economy when QE2 concludes in the not too distant future. As per their responses, the CFO’s are currently unphased. They are telling us not to worry. Again, the reason it has paid to check in is that their track record at key real world US economic inflection points of importance has been fantastic. Will it be so again as we move ahead? For now, I would not bet against them. And the message looking out over the next quarter or two is no slow down. Beyond that, we'll just have to see. Please remember that this survey was completed well in advance of the Japanese tragedy, but certainly amidst Middle East violence and regime change.
To put just a touch of emphasis behind this, remember that in 3Q of 2010 CFO optimism did a virtual swan dive. Again, right on the money in terms of rhythm and pacing as the economy was indeed slowing, leading indicators were turning down and headline economists moods were darkening. As 4Q rolled around, CFO spirits snapped back…just in time for QE lite and QE2. They got it right, so again we listen and take the message seriously into decision-making consideration. No jumping off the side of the economic ship for now, although again this was done pre-Japan. We simply need to keep this fundamental reality in mind amidst the increased volatility of the moment.
Earnings and forward capital spending plans, how we lookin’? Answer? Not too bad. CFO expectations for forward corporate earnings growth diminished a touch relative to last quarter, but the expected earnings growth rate remains very elevated from an historical perspective. Very much in sync with the message of headline optimism for now. And on the capital spending plans front, as is clearly visible, we’ve gone to new highs for the entirety of the period shown below in the bottom clip of the chart.
That’s good news for the manufacturing side of the US economy, as has exactly been playing out in the headline ISM numbers as of late. Anecdotal evidence has shown us that a lot of the actual cap spending is for equipment and plant replacement, not new or green field investment, but it’s dollars and cents cap spending recovery regardless of final destination. As I’ve maintained personally, cap spending is a reflection of confidence. Regardless of confidence surveys, per se, what shows confidence more brightly than willingness to spend hard earned money? Not much. Does this mean the industrials and materials sectors remain strong? We need to keep an eye on China as part of the answer to this question and now certainly Japan, although it will be some time before demand from Japan materializes in the manner a number of Street pundits have been pontificating. It's clear China is slowing from such a torrid pace of the prior years, but slowing to what (growth rate) remains the key question. I personally believe it's still a very good bet PBOC monetary tightening is far from over, and that has implications for the Chinese economy and by extension global industrial and materials sectors. But it could very well be that levered liquidation as of late in the commodity space gives China a bit of breathing room for a while.
Of course I could not leave this portion of the discussion without a quick peek at just how the CFO’s of this fair land feel about inflation. In terms of honesty and integrity, the inflation question to the CFO’s is couched in terms of a change in prices of their own firm products/services. They are talking about their own plans to raise prices, much as is the case with the small business pricing data from the NFIB. The chart below tells the story quite simply, no? You'll remember that the CFO's rank their top concerns each and every quarter. This was the first quarter over the data history we have where "price pressure" made the top five list of concerns. Specifically the CFO crowd cited fuel and commodity price pressures. Adding a bit of change at the margin fuel (no pun intended) to the fire, 76% of manufacturing firms expect capacity utilization to rise relatively meaningfully. You may know that one of the popular academic arguments against inflation is that US capacity utilization has remained low relative to historical experience in the current cycle. Spare capacity means no inflation, right? Of course my usual response is a question - what is the capacity utilization rate for energy and ag commodities? It's about the global. The game has changed.
Finally, and I’m sorry to burn the digital space, a very quick lift out from the report itself.
"Many of our surveyed firms have grave concerns about inflation," said Campbell Harvey, a professor of finance at Fuqua and founding director of the survey. "We asked these inflation-vulnerable firms what would happen to earnings growth if there were "surprise" inflation of 4 percent in 2011 compared to the current rate of 1.5 percent. If inflation surges to a hypothetical 4 percent, CFOs report that earnings growth would be slashed by an astonishing 48 percent."
Remember when you read the quote above the professor is referring to earnings growth (rate), not actual nominal earnings. The nominal earnings growth rate estimate as per the current survey came in at 18.1%, which is a big number. But it says something about how CFOs see vulnerability of corporate margins to inflation. Again, I think it's important in light of all the anecdotes of inflation now surrounding us that now the CFO's are highlighting inflation as an important issue when it had never really been mentioned in any meaningful way prior.
Two last points. The CFO's expect employment growth of 1.2% ahead. That's very modest and if applied to the total current employed base, we'd be looking at job growth of about 130,000 monthly over the next year. Not bad by any means, but certainly light years away form what we have experienced in prior US recoveries. I pontificated early in the year that we would see job growth this year. It's just that it would be modest at best. This is exactly what we hear the CFO's saying as of now. Secondly, CFOs expect dividends will increase by 14% this year. Important because this was the largest quarterly increase in the history of the survey.