Earnings Season Reaches Home Stretch

Equity markets rose for a fifth straight week, as investors continued to price in additional action by the Fed and ECB.  For the week, the S&P 500 rose 1.1% and the Dow Jones Industrial Average advanced 0.9%.  In the past five weeks, the indices are up 3.8% and 3.4%, respectively.

 

In the absence of any real news, investors closely scrutinized statements by European officials last week.  Markets rallied after German Chancellor Angela Merkel’s spokesman Georg Streiter remarked that she was “not worried” about ECB President Mario Draghi’s statements advocating a new bond buying program.  This seemingly innocuous statement raised investor sentiment, as Germany has been one of the primary obstacles to more aggressive action from the central bank.

 

In other news, Republican Presidential nominee Mitt Romney announced Wisconsin Congressman Paul Ryan as his running mate for this fall’s election.  Ryan is well known for his ambitious deficit reduction plan, which would dramatically cut entitlement programs and reshape the US tax code. Some pundits believe Ryan’s selection could cost Romney Florida, because of the swing state’s high density of elderly voters, although it could boost support in the Midwest.  Ryan’s selection also reshapes the election from a referendum on President Obama and the economy to competing visions on long-term fiscal reform in the US.

 

Q2 earnings season continued to wrap up last week, as 447 companies in the S&P 500 have now reported.  According to FactSet, 70% of companies reported earnings above their consensus estimate, slightly lower than the average over the prior four quarters.  As has been previously noted here, the biggest take away from this quarter’s earnings season is the sharp drop-off in top line growth: just 43% of companies beat their sales expectations.  This level is 20 points below the average of the past four quarters, and is the lowest level since Q1 2009.

 

A less sanguine earnings picture emerges when looking at a broader pool of US companies.  Data from Bespoke Investment Group, which has compiled results on 2,192 companies since earnings season began, reported that just 58.8% of companies beat estimates.  This is 3.5% below the average witnessed since 1998, and the lowest beat rate of the economic recovery.  The ratio of companies beating estimates has slowly trended down as earnings season has worn on.

 

Source: Bespoke Investment Group

 

Why the discrepancy?  Not surprisingly, blue chips are holding up better in the face of greater economic uncertainty than smaller cap stocks.  The Russell 2000 beat rate is well below that of the S&P 500.  This has been reflected in market performance: while the S&P 500 and Dow Jones have trended up in the past six weeks, small caps have been flat to slightly negative.

 

It was a relatively thin week of economic data last week, but there were a few reports of note.

 

On Tuesday, the Federal Reserve released consumer credit data for June.  Credit outstanding increased $6.5 billion, the tenth straight increase in the series.  June’s figure was the weakest since October, however, and sharply below estimates for a $10.3 billion gain.  Softness was attributable to a decrease in revolving credit (credit cards), an unsurprising development given the weakness in consumer spending during the second quarter.  Non-revolving credit continued to exhibit strength, particularly in the form of student loan demand.

 

The US trade deficit narrowed again in June, as falling imports shrank the trade gap from $48 billion to $42.9 billion.   Falling oil prices partially explained the decline, as the petroleum gap narrowed by $2.3 billion.  However, a drop of more than $3 billion in goods imports, excluding petroleum, helped fuel the smaller deficit.  Unfortunately, this reflects weaker domestic demand from consumers and corporations.

 

Initial jobless claims appear to be stabilizing at lower levels following a period of volatility.  Recall in early June that claims fell from 376,000 to 352,000 due to seasonal distortions related to a delayed auto manufacturer shutdown.  After a subsequent spike back up to 388,000, jobless claims have averaged 362,000 for the past three weeks.  As a result, the four-week moving average has now fallen to 368,000, the lowest level since April.

 

 

Last week’s claims data was slightly better than expectations, which has been occurring more frequently of late as analysts become more conservative with their estimates.  This is reflected in the Citigroup Economic Surprise Index (CESI), which reversed its negative decline in recent weeks.  While still in negative territory, the index’s improvement suggests that the pace of disappointing data has slowed. Any perception of improvement is a positive development for investors amid an otherwise dour economic climate.

 

 

China Growth Threatened by the West

As we head further into the second half of 2012, it is clear that policy from central banks in the US, Europe, and China will drive markets and the global economy. Monetary policy in the US is becoming less impactful, while central bankers in Europe appear unwilling to tackle the enormity of their collective problem. It could be China that provides a sparkplug for second half global growth, but if Chinese officials prove unable to stem weakening growth, we could face an assualt on growth from more fronts than previously anticipated.

In the latest week, investors received unfavorable news about the Chinese economy in the form of disappointing new loan growth and exports. 

 

In July, year-over-year export growth fell to 1% from 11.3% in June.  It should be no surprise that Europe is the biggest culprit behind China’s export weakness.  Exports to Europe fell more than 16% last month.  Europe is not the only trouble spot for China, though.  Exports to the US fell to a 0.6% increase from more than 10% in June.  

 

Source: AlphaNow

 

Internally, the situation does not appear much better.  Chinese banks originated 540.1 billion yuan of new loans in July, well below Bloomberg survey estimates for 700 billion yuan.  According to Bloomberg, July was the weakest month for loan growth since September 2011. 

 

Source: AlphaNow

 

Economists are increasingly fearful that the recent string of economic misses is setting the table for a disappointing second half of the year in China.  Chinese officials have uncharacteristically admitted that it will be difficult to reach certain growth targets. 

 

One factor working in favor of Chinese officials is the recent deceleration in inflation.  Consumer prices were higher by 1.8% in July from the prior year and down dramatically from the peak of 6.5% in mid-2011.  This opens the door for new monetary easing measures in the Far East.  Officials already cut interest rates this year and reduced the reserve requirement ratio for banks. 

 

Source: AlphaNow

 

Equity markets in China doubt the possibility that government officials can dig out of the current hole.  The Shanghai Composite index continues to plumb new lows, despite a rally in recent weeks. 

 

 

With export growth to China’s major trading partners falling and banks cutting back on new lending, it appears that China is heading towards a difficult second half of the year.  Chinese officials continue to have a number of tools at their disposal to combat weakening growth and the leadership transition taking place later this year makes it highly unlikely officials will want to start their new term on unstable footing.   Between Europe, the US, and China, it becomes ever more difficult to determine which is the tail and which is the dog. 

 

the week ahead

Economic data picks back up this week, with retail sales, CPI, housing starts, and industrial production reports on tap.  The NFIB Small Business survey is also an important indicator to watch.

 

On the corporate front, earnings season winds down with results scheduled from Sysco, Saks, Home Depot, Deere & Co, Aeropostale, Dollar Tree, and Walmart, among others.

 

Central banks meeting this week include Turkey and Chile.  The Bank of England also releases minutes from its most recent meeting.

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