With GDP slowing and housing working through a recession, who is carrying the economy? Is it the corporate sector as many have forecasted, taking the baton from the consumer with pundits touting that corporate balance sheets are strong? Or is the U.S. consumer going to continue its addiction for debt and continue consuming? This week I'll focus on the corporate sector and have a look at the consumer next week. Let's have a look at what economic reports are presently saying below on the corporate front.
The Corporate Sector
Analysts are right to point out the health in the corporate sector as quarterly profits have consistently come in with double-digit gains on a year-over-year (YOY) basis for years now.
Figure 1
Source: Moody's Economy.com
However, what is also clear is that the trend in corporate profits is slowing, with Q4 2006 profits down 0.3% from Q3 2006, though the YOY rate came in at a very respectable 18.3%, though down from the 30.56% rate seen in Q3 2006. The argument many financial and economic pundits are making is that with pristine balance sheets, corporations will pick up the slack in the economy from a weakening consumer. In essence, corporations will continue to spend and take on more leverage by expanding their businesses. Is this happening? Yes and no.
Corporations are taking advantage of their pristine balance sheets and the low interest rate environment by taking on more debt as corporate debt growth reaccelerated after what appeared to be a peak earlier last year. Corporate debt growth came in at 6.5% Q3 after peaking at 9.6% in Q1 2006, but reaccelerated to 10.9% in Q4 2006. Can corporate debt growth compensate for decelerating household growth to support the economy?
Generally both the corporate sector and household sector debt growth trends move in unison, with household debt growth leading the corporate sector. There has only been one period in the last 50 years where corporations continued their debt growth while the consumer segment contracted.
The period occurred in the middle 1960s as consumer's retrenched while the corporate sector also retrenched briefly before reaccelerating its debt growth, and presents a possible scenario to the current picture. In Q2 1966, corporate debt growth peaked at 12.4% and then fell to 9.1% in Q4 1966. It then reaccelerated to 13.6% in Q4 1967 to help offset the decrease in consumer debt growth which peaked at 11.1% in Q1 1965 and bottomed at 2.8% in Q4 1966.
Figure 2
Source: Moody's Economy.com
The expansion in corporate debt growth helped to stave off a recession, while consumer debt growth slowed as it provided enough time for the consumer to retrench, reaccelerating its debt growth and contributing to expanding the economy before a recession could occur.
The question then is, if corporate debt growth has reaccelerated and reached a new high in terms of growth in the current expansion, where is the money being spent? Are corporations hiring more workers and expanding capacity to help keep the economy afloat, or is the money being spent elsewhere? Figure 3 below clearly shows that corporations are taking on more debt, with corporate borrowing reaching peak levels last seen in 2000, but what is also clear is where this money is being spent when looking at Figure 4.
Figures 3
Figure 4
Source: Moody's Economy.com
Although corporate debt growth is at comparable levels to the peak seen in 2000, corporate share buybacks have far exceeded the prior peak seen in 2000 at the height of the last equity bull market. This indicates that, although the total debt growth currently is similar to that of 2000, less of the debt taken on by corporations is going towards capital investment and being directed towards share repurchases. Does this sound like corporations are confident about future growth opportunities, or does it sound like they are reducing their share net to support earnings-per-share (EPS) in the future as their profits are slowing? Doesn't sound like a resounding vote of confidence in the economy, or maybe more specifically the outlook on U.S. consumer's spending prospects.
What is likely on corporate executive's minds and why they are funneling money towards equity repurchases instead of capital spending are the slowing in manufacturing and housing. Durable good shipments excluding defense just turned negative on a YOY rate of change basis, down 0.08% in February. The last time this series went negative was in November 2000, just a few months prior to the last recession. Clearly not a positive development and likely something business executives are paying close attention to.
Figure 5
Source: Moody's Economy.com
The trend in durable goods shipments (ex defense) closely matches that of employment while leading employment by roughly three months, pointing towards a deceleration in employment further ahead as corporations are likely to cut payrolls, not expand them.
Figures 3 & 4 above illustrate that a larger percentage of corporate debt growth is going towards reducing corporate equity share count than was seen in 2000, but how much is being poured into capital spending in the U.S.? Looking at the gross private domestic investment component of GDP shows a strong deceleration in investment, which came in at a negative 1.12% YOY rate of change in Q4 2006. This is alarming as there have only been two occurrences (1967, 1987) out of thirteen in the past 50 years where a recession was not seen when the YOY rate of change turned negative, with a recession occurring 85% of the time.
Figure 6
Source: Moody's Economy.com
Not surprisingly, the main drag on total gross domestic investment is from residential fixed investment (red line), which is currently down 12.8% YOY, though nonresidential fixed investment (blue line) appears to be rolling over.
Figure 7
Source: Moody's Economy.com
Looking into the components of nonresidential fixed investment shows both components, structures (orange line) and equipment & software (blue line), decelerating on an annualized basis. Equipment and software spending is down an annualized rate of 4.77% and the structure component (commercial real estate) is just barely positive, up an annualized 0.82%. The present picture in the figure below closely resembles the picture seen just prior to the last recession when nonresidential fixed investment and its components were all negative. With the structure component falling from an annualized rate of change of 20.33% in Q2 2006 to a meager 0.82% in Q4 2006, it is likely to turn negative in the first quarter of this year as the momentum is clearly to the downside.
Figure 8
Source: Moody's Economy.com
The equipment and software component of nonresidential fixed investment is seen as a proxy for capital spending, and the negative 4.4% annualized rate in Q4 2006 clearly indicates that businesses are cutting back on spending as they did heading into the 1990 and 2001 recessions. The figure below throws out the argument that corporations are going to come to the economy's aid and pick up the slack from the consumer.
Figure 9
Source: Moody's Economy.com
The trend in capital spending in the U.S. should be sending a warning signal to the investment community and the Fed that things are not as rosy as some may wish to believe. In fact, the Fed has already indicated they are aware of the deceleration as seen in their January FOMC minutes, which mentioned the following:
'Business fixed investment overall continued to be weaker than anticipated, suggesting some caution on the part of businesses in expanding capacity. Nonetheless, participants expected that, going forward, favorable financial conditions, strong corporate balance sheets, high profitability, and growth in sales would support a firming of investment spending.'
The rosy outlook from the Fed remains to be seen until the Q1 2007 GDP report comes out on the 27th of this month. If the trends in the figures above continue, this rosy outlook is far from certain and investment spending is likely to continue to contract, not firm as the Fed would hope. Looking at the figures above do not support the argument of the corporate sector carrying the baton from the consumer as a retrenchment is underway in capital spending, and corporations see a more attractive investment in retiring their equity share count instead of capital investment to fuel growth. Is this a vote of confidence coming from the corporate sector on the outlook of our economy? Hardly, and the following concluding figures from the National Federation of Independent Business make this abundantly clear as the trends are clearly negative.
Figure 10
Figure 11
Source: Moody's Economy.com
What Spending Slowdown?
I came across an article in the April 23, 2007 issue of BusinessWeek after I had written this WrapUp that explains the meager capital investment by U.S. corporations and sheds some light on where the debt growth is being funneled. The article by Michael Mandel entitled, "What Spending Slowdown? Forget those antiquated government statistics. U.S. corporate investment is booming--just take a look overseas," points out U.S. corporations are increasing their investment spending, just not domestically. Excerpts from the article are provided below and I will leave the implications to be drawn by the reader:
Corporate America is still spending big time, just increasingly outside the U.S. A BusinessWeek analysis of financial reports from more than 1,000 large and midsize U.S.-based companies shows that global capital expenditures in the fourth quarter of 2006 were actually up 18.1% over the previous year. The comparable growth for domestic business investment, which is all the government reports each quarter,: only 8.9%, without adjusting for inflation.Welcome to the global economy, Mr. Statistician. Government measures were well-suited for the 1950s and 1960s, an era when U.S. companies mainly invested at home, and imports and exports were a relatively small portion of the economy.Today, however, virtually every major company is trying to reduce costs and get closer to fast-growing markets by spreading manufacturing operations and research facilities around the world. As a result, a U.S.-centric view of capital spending, says Steven R. Appleton, CEO of Micron, is 'almost meaningless.'"I don't have to hire one more person in the U.S.," says Appleton. "I don't have to invest one more dollar here--and we'll be just fine." (emphasis added).Appleton's sentiment is particularly striking, since Micron invested 100% of its capital spending domestically as recently as the late 1990s. But plenty of other companies are making the shift abroad as well.For example, 3M expects to spend about .5 billion in cap-ex in 2007, up about 25% over last year. Out of 18 new plants or major expansions in the works, only seven are in the U.S. Four are brand-new facilities in China, with others in India, Korea, Poland, and elsewhere.TODAY'S MARKET - Economic Reports
MBA Mortgage Applications Survey--Week of 04/13/07
Mortgage demand fell 2.5% last week led by a 4.2% decline in purchase applications and a 0.3% decline in refinance applications. The decline in refinance activity was likely the result of rising mortgage rates as the contract rate on the 30-year FRM increased 6 basis points to 6.12% while the 1-year ARM remained at 5.89%. The FRM is 16 basis points higher than four weeks ago, and the ARM is one basis point higher than four weeks ago.
Source: Moody's Economy.com
Looking into the MBA mortgage data and the NAHB Housing Market Index data, DismalScientist, a product of Moody's Economy.com, had the following commentary:
The decrease in purchases is consistent with anecdotal tales of mortgage lenders partnering with other industries to offer free trips or other benefits to attract customers. Essentially, the subpar numbers for March housing starts and permits combine with the exceedingly low April NAHB Index of homebuilder optimism to indicate that the residential mortgage market is nearing a precipice during what are traditionally its strongest months.The primary housing market is weak and offering no indication that the bottom is coming before summer. Mostly, the market reflects a decrease in the supply of loanable funds from rising defaults; this is concurrent with a lack of demand from potential buyers because of high house prices, high interest rates and tighter lending standards. U.S. job growth was solid last month and an early Easter helped retailers, but expects that the housing industry may weaken sufficiently to pull real GDP quarterly growth down near or below 2% (annualized) before this autumn.All three components of the NAHB Housing Market Index record the lowest overall optimism for April in the 20+ years of the survey. The worst may be yet to come, as mortgage delinquency and default rates are spiraling upward to levels not seen since recessions during the last couple of decades.Oil & Gas Inventories--Week of 04/13/07
Crude oil inventories fell 1.0 million barrels last week, in contrast to expectations of a 0.6 million barrel increase. Gasoline inventories continued their slide, falling 2.7 million barrels, with gasoline stocks well below the average range for this time of year (see figure below). Distillate inventories fell 0.8 million barrels while expectations were for a 0.6 million barrel drawdown. All three energy levels are below last year's levels, with gasoline inventories down the greatest (-5.6%) followed by crude (-3.5%) and distillates (-0.9%). Refinery activity rose to 90.4%.
Source: Energy Information Agency (EIA)
Source: Moody's Economy.com
Source: EIA, This Week In Petroleum
Moody's Economy.com Risk of Recession--March
Moody's Economy.com's probability of recession index rose sharply to 27.6% in March, up 6.4% from February's reading of 21.2%. The increase in the index came from a sharp moderation in consumer confidence, the equity correction in March, and a further inversion of the yield curve.
Source: Moody's Economy.com
The Markets
The Dow Jones Industrial Average closed above 12,800 for the first time, setting an all-time record. Despite the move in the Dow the markets were mixed with the NASDAQ down 6.45 points to close at 2510.50 (-0.26%) and the S&P 500 was up slightly, rising 1.02 points to close at 1472.50 (+0.07%).
Investors bought Treasuries today with the 10-year note yield at 4.654%, falling 3.4 basis points. The dollar index was down on the day and approaching a 15-year low, falling 0.14 points to close at 81.68. Advancing issues represented 42% and 39% for the NYSE and NASDAQ respectively, with up volume representing 47% and 49% of total volume on the NYSE and NASDAQ, reflecting a mixed trading day in the markets.
Energy prices were mostly up on the day after release of petroleum inventories. Gasoline inventories continue to plummet despite rising refinery activity due to strong demand and lagging imports with one month gasoline futures rising 1.42%, and a 4.40% spike in refining margins (3-2-1 crack spread). Precious metals were up on the day aided by a falling dollar with gold rising .20/oz to 9.75/oz (+0.47%) and silver up __spamspan_img_placeholder__.08/oz to close at .98/oz (+0.58%). Base metals were mostly up with zinc showing the greatest strength on the day (+4.55%), while tin displayed the weakest performance (-1.98%).
Overseas markets were mixed with Japan's Nikkei 225 index putting in the strongest showing, up 0.80%, while Germany's DAX index displayed the greatest weakness, down 0.90%.
The mixed trading in the markets on mostly down volume was evident with only three of the ten S&P 500 sectors up on the day, with financials (+1.01%), industrials (+0.42%) and utilities (+0.26%) putting in the only advances. The greatest weakness was seen in materials (-0.75%) and energy (0.67%).
