A Tale of Two Economies

by: Caleb Sevian

With nearly 80% of companies having reported for Q3, S&P500 earnings have been extremely strong with 17% year over year gains and nearly 75% of companies exceeding estimates according to Thompson Financial. This compares favorably with the long-term trends of 8% earnings growth and 60% of companies exceeding estimates.

The trend of above average earnings gains appears to be coming to a close as Thompson Financial numbers expect Q4 2006 year over year earnings growth to be 11% and Q1 2007 to be back to trend at 8.4%. The slowing trend has been broadly supported by economic data foreshadowing slower economic growth in the coming quarters led by a softening housing market and an American consumer strapped to find his next source of low interest borrowing to support his spending habits.

Although much of the economic data flowing in seems to point to weakness, pockets of strength in the economy continue diverge from the downtrend and appear to be pointing to accelerating economic strength. Take for instance the Institute for Supply Management indexes: The ISM Factory Index’s latest reading was a lean 51.7 and is trending down, any number above 50 signals an economic expansion, while the ISM Service Index’s latest posting was 57.1, suggesting continued robust expansion in the service sector.

Friday’s unemployment data showing an unemployment rate of 4.4% further supported the argument that there are areas of the economy that continue to thrive despite the struggling housing and auto sectors. With nearly three quarters of the economy based on the service sectors, what the numbers appear to be highlighting is the continuing shift away from a manufacturing economy into a service economy that seems to be healthy.

Same store sales give us some ancillary information supporting the assertion that two areas of the economy have developed. Last week Walmart announced that same stores sales at stores open at least one year are expected to be flat, yet the same day many high end departments stores and designer brands such as Guess reported strong same store sales. This data suggests that lower income consumers, typically found in the manufacturing sectors, are feeling pressured, whereas higher end consumers that may be found in the service sectors are continuing to experience wage expansion. Perhaps the failure to adequately separate out the two distinctly separate areas of the economy is leading many market goers to feel confused about exactly which direction the economy is going.

This all may be a moot point if inflation continues to be trend against us forcing the Fed’s hand as a hawk. Last week productivity numbers were released indicating that Q3 productivity was flat and Q2 was revised down to 1.2%. The Fed has made allusions to productivity being the key to low inflation in times of wage growth and tight labor markets. They have also said as long as productivity out paces PCE currently at 2.4% the economy may be able to fight off inflation pressures internally.

This measure is now tilting the Fed towards a potentially more hawkish stance. We saw support of this in the Fed Fund Futures markets last week on Friday when the probability of a Fed cut in January or February moved to zero.