"There's more than one way to skin a cat.”
-Mark Twain, A Connecticut Yankee, 1889
Conclusion: Though earnings season is off to a fairly healthy start, we urge substantial caution to anyone buying equities right now in hopes economic growth will rebound enough to reach the $96.92 target consensus has forecasted for 2011 S&P 500 EPS. Aided by an ailing consumer, our call for slowing US GDP growth looks firmer by the day.
Current Virtual Portfolio Positions: Growth Slows (Short: SPY, XLI, NKE, and SAM; Long: FLAT) as Inflation Accelerates (Short: ELD; Long: FXC, FXB, SU, PBR, Gold, Crude Oil, and the Chinese Yuan).
At the beginning of the year, the delta between Hedgeye estimates for the slope of domestic growth and inflation and consensus’ overly bullish forecasts for GDP and CPI were as wide as they’ve been since early 2008. Nearly four months into the year, that spread has narrowed quite substantially as the sell side has begun to capitulate on both fronts in the last several weeks.
While normally we’d look to fade sell side capitulation (i.e. get longer of risk assets), careful analysis of their collective behavior reveals that they haven’t really “capitulated” at all. In fact, the Bloomberg Consensus Real GDP Forecast has increased on a YTD basis for each of the four quarters of 2011. That’s remarkable, considering the peak-to-trough decline of the 1Q11E estimate of (-90bps)! Interestingly enough, the 4Q11E estimate has been ratcheted up alongside the 1Q11E estimate’s last leg down. Sell side forecasts for all-time high S&P 500 earnings have to be achieved somehow…
As Daryl Jones penned in a note yesterday titled: “Consensus Meets The Hedgeye: Q1 GDP Estimates In Freefall”, our conviction in the simple theme we introdued six months ago remains unshaken. That message remains: Growth Slows as Inflation Accelerates.
At the start of the year, the biggest risk to our bearish bias for US GDP growth was, in fact, improvement in employment statistics – which was to be expected, given the confluence of their traditionally lagging nature and 4Q10’s robust growth figures. As such, we’ve seen the Unemployment Rate tick down in recent months alongside recent strength in Nonfarm and Private Payrolls growth. The go-forward outlook is certainly less bullish, however, with Rolling Initial Jobless Claims now trending sideways for the eighth week in a row.
It doesn’t come as a conceptual surprise to us that employers aren’t opening up their coffers and taking on additional labor expenses as The Bernank’s Inflation continues to make higher highs in the form of some of the most expedited rallies we’ve seen across commodity markets in many years. Simply put, as input prices increase, producers are forced into pulling various operating levers to protect profit margins – an effect compounded by the certain companies’ public status (gotta meet the street’s earnings estimates somehow…).
The net result of their collective choices has been to slow hiring plans and limit wage growth; the latter is doubly affected by the former as a slack labor market limits the bargaining power of current employees for wage increases. Average Hourly Earnings growth has slowed to a +1.7% YoY growth rate in the last two months from +1.9% YoY in January.
On the hiring side, we’ve seen a similar slowdown. NFIB’s Small Business Plans To Hire Index slowed to 2 in March from 5 in February; on a 3-month moving average basis, the index slowed to 3.3 vs. 4.7 in the prior month. The ISM data points to a similar slowdown in hiring plans. Using a weighted average of the Employment subcomponents within the Manufacturing (30%) and Non-Manufacturing (70%) Reports on Business Surveys, we’ve created an index that accurately tracks Private Payrolls growth on a concurrent basis. It’s interesting to note that this index just backed off its all-time high of 58.3 in February ’11 to 56.5 in March. While, in theory, the index could continue to make higher all-time highs from here, we know that ISM readings above 60 are typically not sustained – especially when they are 1.6 standard deviations above the long run average. Thus, reversion to the mean seems likely for this series, just as slowing jobs and wage growth seems likely for the US economy.
So why is US economic growth slowing? Well, aside from Housing Headwinds, a potential currency crisis, burgeoning sovereign debt, and depressed consumer confidence stemming from natural hazards and geopolitical risk (alongside the centrally-planned fear mongering associated with crisis ZIRP), the most tangible thing we can all agree on is accelerating inflation. Whether you agree with our thesis that the uptick in inflation that continues to be reported on a global basis is a function of Burning the Buck is beside the point. Both market prices and government statistics are pointing to higher prices for global consumers.
What does that mean to consensus’ “resilient” US consumer? It means that the consumer will increasingly fill the pinch of higher prices and depressed wage growth. While members of the Keynesian Kingdom will continue to tell you that there’s no inflation if wages aren’t appreciating, we market practitioners realize the glaring lack of common sense associated with this academic fallacy. As such, we’ve taken the liberty to create alternative measures of inflation for a more useful gauge of consumer prices.
Along these lines, we’ve introduced our original Hedgeye Inflation Index last year, which simply attempts to measure the spread between what consumers buy and they earn. Since we’ve introduced the project back in early 2010, we’ve made a few additions to make it more robust, given the natural limitations associated with using the CRB Index as a proxy for consumer prices. As such, we are now equipped with the following measures of inflation:
Hedgeye Inflation Index (Original): YoY % change in CRB Index less the YoY % change in Average Hourly Earnings. We use the CRB Index as a proxy for prices here because its daily price quotation allows for a real-time, up-to-the-minute gauge of inflation.
Hedgeye Inflation CPI Index: YoY % change in Headline CPI less the YoY % change in Average Hourly Earnings. We use Headline CPI here because of its encompassing nature, particularly relative to the market prices of commodities. While the series has been repeatedly adjusted throughout history to limit COLA expenses for the federal government, we cannot deny its appeal as a broad-based, official statistic.
Hedgeye Inflation Chinese Import Prices Index: YoY % change in Chinese Import Prices less the YoY % change in Average Hourly Earnings. While the series may appear out-of-place to the naked eye, careful analysis of the products the US imports from China lend credence to this selection (ranked in order of largest to smallest): electrical machinery and equipment; power generation equipment; apparel; toys, games, and sports equipment; furniture; footwear; plastics; iron and steel; leather and travel goods; and optics and medical equipment.
Hedgeye Inflation Expectations Index: University of Michigan 1Y ahead Inflation Expectations Index less the YoY % change in Average Hourly Earnings. This derivative is designed specifically to capture the consumer’s own expectations of the spread between his income and expenses. It’s worth pointing out that the +2.9% spread (or +290bps) is the highest ever reading in this data series (starting in March ’07). The consumer knows he’s getting squeezed on the P&L.
No matter how you skin this cat, the net result is that inflation is up and to the right.
What does this all mean for consumption growth (~70% of the US economy)? Net-net, it means that the consumer has less discretionary income to spend after nondiscretionary purchases are made. As such, we’ve seen a measured slowdown in discretionary spending over the last few months as The Bernank’s Inflation started to show up measurably at the pump. We’ve taken the liberty to create an index to track consumer discretionary spending trends. Interestingly enough, growth in the Hedgeye Consumer Discretionary Spending Index has inflected in a fairly meaningful way, slowing to +1.3% YoY in February vs. its cyclical peak of +5.2% YoY in December ’10. As we receive more up-to-date data points in the coming weeks, it’s important to keep in mind that growth decelerating to below +1% YoY has proceeded the last two recessions.
All told, we maintain our bearish outlook for the slope of US growth over the intermediate-term TREND, largely due to the Consumption Cannonball, which looks to gain steam in the coming months. We underestimated the consumer’s resiliency in 4Q10 when we introduced this thesis. We don’t anticipate we’ll be making the same mistake of being too early this time around.