Recovery's Got Legs

Although there were a lot of economic indicators this week, news items out of our sector teams were far more interesting and indicative of an economy in the early stages of an extended recovery.

The tech, manufacturing, and even the farming sectors weighed in with some powerful results. In general, there have been large earnings surprises, and for a change a significant portion of companies are reporting revenue surprises as well.

Frankly, the sub-3% consensus real GDP forecast isn't looking consistent with earnings growth expectations of 30% or more in 2010. Based on my discussions with our analyst teams, it seems more likely the GDP forecasts will have to move upward than earnings forecasts will move downward. Furthermore, it's not out of the question that earnings in 2011 could exceed the previous high-water mark for the S&P reached in 2007.

Discount Rate Increase Has Little Meaning
This week's regular economic indicators were positive, on balance. Housing starts improved, consumer prices remained well-contained while industrial production soared, and the regional purchasing managers' survey held out the promise of even better results in the months ahead. My prediction of 4% or more growth for 2010 driven by manufacturing and exports continues to hold. However, producer prices did jump, primarily due to volatile energy prices.

The Fed also raised its discount rate, but that's a non-event (or maybe even a slight positive) in my opinion. If anything, it means the Fed has greater confidence that the economy is improving more than it is letting on. As a practical matter, no business or consumer loans are lent at this rate, which was increased to a still miserly 0.75%.

Trading up from Wal-Mart to Whole Foods
This week there were a lot of interesting stories out of our coverage universe that speak to an improving economy.  Whole Foods  , a company known for high-quality but pricey goods, saw sales rise last month for the first time since September 2008. Profits surged 71%, and management raised its revenue outlook.

Meanwhile, value-oriented  Wal-Mart (WMT) saw same-store sales in the U.S. decline about a percent in the latest quarter, and the forecast for the quarter ahead remained mired in the range from negative 1% to 1%. Some pundits are positing that the consumer is feeling a little more confident and just might be trading up--perhaps a stretch, but still an interesting data point.

Hewlett-Packard Shines in the Tech Sector
On Thursday I was very excited to see quarterly PC unit sales for  HP (HPQ) surge 26% from a year ago, a least partially due to the shipment of Windows 7. Tech is always an important leader in the economy, and HP is a key bellwether. As one might suspect,  Dell  announced sales the next day that were less robust, given that Dell's bread-and-butter business customers are a little slower to react to a recovery than retail consumers. Still, the good news from HP combined with  Cisco's (CSCO) comments from a couple of weeks ago should bode well for the tech recovery.

 Deere's (DE) results were also positive this week and point to an improving farm economy, according to senior industrials analyst Adam Fleck. More important than the decent current results was an announcement that the company now expects revenues in North America to be flat versus its previous expectation of a 10% decline. Worldwide retail revenue growth is now anticipated to be in the low single digits aided by pricing, overseas growth, and currency benefits. These are trends I'm seeing across many of the manufacturing firms that we cover.

Inventory Ratio Near the Best Levels of the Last 18 Years
The all-important inventory/sales ratio improved dramatically in December to 1.26 according to the Census Bureau, well off its high of 1.46 in the previous December, representing a solid recovery. The inventory/sales ratio is now below where it was when the recession began in December 2007. In fact, the ratio was only lower for four months at the end of 2005 (at 1.25) in the entire 18-year history of the index. The lower this ratio, the higher the probability that manufacturers will have to actually build something to meet customer demand.

Tight inventories and the need to expand them showed up in some of this week's company comments. Hewlett-Packard noted that it could have shipped more printers if additional inventory had been available. Chrysler had to shutter its Belvidere plant for a couple of days due to a lack of parts. Even in the lumber industry, plant closures have caused tighter inventories and higher prices.

Andy Ng, senior analyst on our semiconductor team, indicates that lack of new fabrication facilities could lead to spot shortages and/or higher prices for select semiconductors by the end of the year. Andy noted that no new fabrication facilities were opened worldwide in 2009, and it doesn't look like more will be opened in 2010. However, in 2011 as many as nine plants are on the drawing board to meet increasing demand.

Manufacturing Sector Powering Ahead
Strength in the manufacturing sector is showing no signs of abating this week as industrial production statistics as well as two regional purchasing managers' reports showed continued growth in recent months as well as potential for even more growth in the months ahead. Industrial production in January was up 0.9% from December. This index has gained roughly 5% from its low in June 2009 but still remains 10% below its peak in early 2008.

That's both good news and bad news. It's bad news because the number is so depressed, still down more from the peak than in any of the last six recessions, even after six months of recovery. But the good news is that there is a lot of runway in front of this economy. If this plays out anything like the recovery from the 1973 recession, industrial production could approach its former peak in 12-15 months. Thus far, the pace of the recovery in industrial production looks very similar to the 1973 recovery according to graphs compiled by Eric Landry of our industrials team, which bodes well for the months ahead.

Regional Purchasing Managers Reports Point to More Good News Ahead
Both the Philly Fed Manufacturing Report and the Empire State Report confirm strong current conditions and suggest even better news ahead. The Empire State Index jumped to a reading of 24.9 from 15.9, while the Philly Fed index moved to 17.6 from 15.2 (anything greater than 0 indicates expansion). This one of the few months in recent history where both indexes (each with a decidedly different base of manufacturers) have moved higher simultaneously.

The all-important new orders subcomponent was in growth mode for both studies, with Philly notably stronger than New York. It is great to see new orders so strong because that becomes the basis for further production down the road, helping sustain the recovery. Inventory reductions, which have been such a drag on this recovery (things shipped out of inventory don't require factories or employees to produce the goods) are also coming to an end according to special questions within the Philly Fed report. Over the past several months, just 21% of customers had reduced inventories (the rest were held flat or increased) compared to the 69% of firms that were reducing inventories a year ago.

The Power of the Manufacturing Sector Underestimated
I continue to believe that many economists are pooh-poohing the manufacturing recovery because manufacturing only accounts for about 15% of employment. But as I've said many times before, manufacturing jobs tend to pay better, and each manufacturing job will also pull through more jobs in the service sector.

Eventually, a better jobs outlook should lead to a better housing sector, where job growth and new home sales are highly correlated. So it looks as if manufacturing, in addition to exports, will be meaningful drivers of the recovery in the months ahead. Then in 2011, better shipments out of  Boeing (BA) (if they really ship the 787), increased semiconductor capital spending, and even renewed growth in housing begin to kick in, potentially providing some legs to this recovery.

Consumer Prices: a Sigh of Relief
Consumer prices for January came in at a modest 0.2% increase. Minus food and energy, the metric was down in January. Just as importantly, October and November were both revised downward. The January figure was below the general consensus of 0.3% and just above my predicted 0.1% increase. Inflation over the last four months has been 0.2% each month, which translates to 2.4% on an annual basis. This range should not spook consumer spending just yet.

Housing Reports on the Docket
Next week will bring a lot of housing data. Both new and existing home sales will be reported, and I don't expect much change in this seasonally slow time of year. The anticipated removal of the housing credit, followed by its reinstatement, should help the data sometime in the months ahead, but the improvement for January is likely to be modest, since the reinstatement has only been in place for a couple of months.

The Case-Shiller Index of housing prices is likely to show a decrease when it is reported on Tuesday according to our housing analyst, Eric Landry. In fact, the index could be weak for the next three reports based on Eric's analysis of real-time listing price data. Since the Case-Shiller data represent a three-month moving average, the index is already a bit stale by the time it's released. For example, while the Case-Shiller data could be down for several months, real-time initial listing prices indicate that recent price declines have slowed through the first few weeks of February.

GDP Growth Shouldn't Evaporate This Time
The second version of GDP estimates is due on Friday. Recall the first version estimated that growth in the fourth quarter was a stunning 5.7%. A negative exports report will weigh that number down, while retail sales and maybe inventories could add to the number. I am betting the revision will be up, but I don't have enough data to be confident. I don't think the report will be like the third quarter, when 3.5% growth evaporated into a more meager 2.2% after all the revisions were completed.

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