U.S. Equity And Economic Review: Earnings Are Less Bad This Time Around

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On Friday, the BEA released the first estimate of 2Q GDP, which was a disappointing 1.2%. However, the report's internals numbers were mixed. Consumer spending strongly increased, rising 4.2%. Durable goods spending was up a very solid 8.2%, while spending on non-durable goods and services also advanced (up 6% and 3%, respectively). However, business investment was very weak: gross private domestic investment dropped a whopping 9.7%; 3 of 4 sub-categories declined (non-residential structures -7.9%, equipment -3.5%, residential investment -6.1%). Finally, the BEA also revised 1Q GDP growth down, this time to .8%.

There are several ways to look at the GDP data. The simplest and most negative is that the U.S. economy is slumping and potentially heading towards a recession. This is the easiest to digest because it relies exclusively on the headline number. But there are several counter-arguments, the simplest of which is that final sale of domestic product increased a fairly healthy 2.4%, signaling that domestic demand is strong. The second counter-argument is more nuanced: there are pockets of weakness (corporate profits and hence business investment) but also areas of strength (the low unemployment rate is increasing consumer confidence and, as a result, consumer spending). Further complicating the picture is the BEA has had difficulty measuring 1Q GDP for the last few years. San Francisco Fed President made the following statement in a speech on May 13:

Although the published data should account for usual seasonal patterns, for myriad wonky reasons that would take too much time - and too much of your patience - to explain, they don't. To correct this problem, my staff has added a second round of adjustment to get a more accurate number. Adjusted in this way, real GDP actually grew over 2 percent in the first quarter. This makes more sense when we look at the rest of the economy - such as the labor market - and is in line with what I'm hearing from the business community, that they didn't see significant drop-offs at the beginning of the year.

Applying Occam's razor, the right answer is the U.S. economy is slowing. And while we're not in a recession, we're getting uncomfortably close. However, the more nuanced answer offers a great deal of insight, complicating the simplistic reliance on the reported number.

The housing market continues to provide positive economic news. New home sales increased 3.5% M/M and 25.4% Y/Y. This data started to increase in September 2015 rising from ~457,000 to its just reported level of 592,000, a post-recession high:

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The ~50 basis point decline in the 30- and 15- year mortgage rate since the first of the year is undoubtedly helping this market.

Unlike the housing market, industrial news was bearish. Durable goods orders declined 4%, .5% ex-transportation. Capital goods without transportation orders increased .2%. The following chart places this data into a 5-year context:

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With the exception of a large spike in 2014, total durable goods have been trending sideways since July 2013. Capital goods ex-transportation orders have 2 trends: they moved sideways between early 2012 and late 2015. They've also been trending lower since mid-2014. This decline occurred in conjunction with oil's price drop, which largely explains the decline. And with oil's rise in 2016, it's likely we've seen the worst of the oil market contraction.

Economic conclusion: at best, this week's news was bearish. The NY and Atlanta Fed's respective GDP predictions called for growth of 2% (which is still possible after revisions); other analysts predicted a higher number. While the report contains strong components, the sharp decline in business investment is alone reason to be concerned about the U.S.' economic health. When the GDP report is coupled with the weak durable goods number, the week's news is bearish. However, housing news continues to show a strong sector, diminishing the combined negative impact of this week's other reports.

Market Overview: markets were marginally lower this week, with the SPYs down a very small .06% but the DIAs down .74% and IYTs 1.5% lower. The QQQs bucked the trend, advancing 1.39%. But the real story this week is the improvement in corporate performance. From Zack's:

The Q2 earnings season is in full swing with results from 208 S&P 500 members accounting for 50.5% of the index's total market capitalization already out. As has been the trend in other recent quarters, growth continues to be problematic, with Q2 on track to be the 5th quarter in a row of negative earnings growth for the S&P 500 index. That said, actual results are turning out to be less bad relative to expectations, with the growth pace modestly improving from the prior quarter's level. Importantly, while estimates for the current period (2016 Q3) have started coming down, they are not falling by as much as was the case at the comparable stage in the prior earnings season.

Total earnings for the 208 index members that have reported results are down -4.7% from the same period last year on +0.4% higher revenues, with 73.1% beating EPS estimates and 51.9% coming ahead of top-line expectations.

From FactSet:

The blended (combines actual results for companies that have reported and estimated results for companies yet to report) revenue growth rate for the S&P 500 increased to 0.1% this past week, which is above the year-over-year decline of -0.3% at the end of last week and the year-over-year decline of -0.8% at the end of the second quarter (June 30). If the index reports growth in revenues for the quarter, it will mark the first time the index has seen year over-year growth in sales Q4 2014 (2.0%).

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For Q2 to date, the percentage of companies reporting revenues above estimates (57%) is slightly above the 5-year average (55%). The aggregate amount by which companies are reporting revenues above estimates for Q2 (+1.2%) is twice as large as the 5-year average (0.6%). So, while both numbers are above average, the surprise percentage for Q2 is the main driver of the increase in the Q2 revenue growth rate since June 30.

Granted, the revenue improvements are small and earnings are still declining. But revenue is no longer sliding and the pace of earnings beats is strong. Even accounting for the fact that companies usually rig their earnings numbers to make it easier to beat the estimate, the picture is still better. And with the current and forward P/E of the SPYs and QQQs still at the upper end of expensive, the revenue and earnings news provides something of a cushion for prices. That makes this latest earnings season a success.

Hale Stewart, XE.com