Q2 Commentary (2008)
Diminished fears about the global financial sector along with optimism of the impact of the fiscal stimulus package fostered a strong equity rally from the mid-March lows through much of the second quarter. As many on Wall Street trumpeted a bottom in the markets and credit crisis and forecast a second half economic recovery, we have long cautioned that the economy was on the verge of a consumer-led recession. Events of the second quarter may have provided the tipping point.
Much of our commentary since 2005 has focused on the contribution of credit creation to our economic growth and the resultant strength in consumer spending. The highly levered consumer facing a major housing correction, lower stock market and declining net worth along with an increasingly tenuous job market would thus be expected to retrench. Additionally, the de-leveraging of the financial system and tightening credit conditions would further curtail spending. What we did not anticipate was the magnitude of the rise in commodity costs.
Overheated growth in developing markets (most notably Asia) combined with exchange rate policies seeking to maximize exports has fed the commodity price inflation and domestic inflation in emerging economies. Indeed through April, inflation in emerging Asia is running at 7.5% y/y, almost a 10-year high and double a year ago. After years of the global labor glut contributing to very low levels of domestic price increases, this has led to the U.S. importing inflation at unprecedented levels. While the period from 1998 to 2007 averaged less than 2% annual import price increases, we are now running at over 17% y/y with even core inflation imports over 6%.
Though core inflation (excluding food & energy) has actually tempered in 2008 led by receding housing costs, headline prices have increased to 4.2% y/y (from just over 2% last year). In the second quarter alone agriculture commodities increased almost 11% in price while the price of oil zoomed over 40% to end the quarter over $140/bbl. The retail national average of regular grade gasoline increased from $3.21 on April 1, to $4.11. It is estimated that the increase of .90/gal in gas prices completely offsets the $120 billion stimulus package. It is no wonder therefore that consumer confidence is at levels not seen since 1980. Real wage growth in the U.S. has turned negative and the job market weakened while the major consumer assets, housing and equities, have declined. We have now seen U.S. consumer net worth post the first drop since the last recession by as much as 10% by some estimates.
The continued decline in the U.S. dollar has strengthened the export side of our economy and trade deficit improvement has contributed a full 1% to GDP growth. The Q4 2007 and Q1 2008 GDP reports technically avoided recession gaining 0.6% and 1.0% respectively (though we would not be surprised to see them subsequently revised downward). The early release of the rebate checks will increase consumer spending and should contribute to a positive Q2 GDP report. Internationally, the developed markets have experienced the same slowing economic and rising inflation headwinds that we have and now may be joined by the developing economies. The International Monetary Fund (IMF) pegged global GDP growth in 2007 at 4.7% and currently estimates 2008 at 4.5%. As the Asian economies slow, we would not be surprised to see the global slowdown move this expectation towards 2% for the year.
The jobs market (a lagging indicator) has weakened considerably with Non-farm payrolls showing year-to-date job losses of 438K and the unemployment rate jumping from the cycle low of 4.4% in March of 2007 to the most recent 5.5%. With initial unemployment claims and continuing claims rising, we expect this to exceed 6% before the cycle bottoms. Though job losses have been less so far in this economic downturn than many previous recessions, much of this may be due to the slower job growth experienced during the recent economic expansion. Additionally and importantly, employers have focused on cutting back the average work week to control costs. As Average Hourly Earnings has increased 3.4% y/y (still below headline inflation), the Average Weekly Earnings have grown only 2.8% as Aggregate Hours Worked has declined.
Much of the turmoil in the credit and consumer markets will continue to be centered on the housing market. While we have seen some hopeful signs of increased affordability along with stabilization in supply/demand imbalances, there is still a long way to go. Delinquencies and foreclosures continue to rise to record levels. The Case-Shiller index indicates that prices have declined over 15.3% over the last year and fully 17% from their peak.
Though we anticipate 2008 will be the second consecutive year of declining S&P 500 earnings, consensus estimates still expect about a 9% gain with a strong second half recovery. With rising input costs and difficult pricing environments, we should continue to see pressure on margins with earnings disappointments the likely outcome. In response to the weakened employment outlook and inflation concerns, the major indices gave back all of the gains since the March lows starting in early June. For the quarter the S&P 500 declined 2.7% bringing the 2008 decline to 11.9% and almost 18% below October 2007 highs. The Russell 2000 small cap index eked out a positive 0.6% gain for the quarter though still down 9.0% for the year. International markets suffered with the developed EAFE index losing 1.9% and 10.6% and Emerging Markets 1.0% and 11.7% respectively for the quarter and year to date..
Global inflationary concerns have taken center stage this quarter from the supporting roles of housing, credit, and the consumer. While we fully expect that inflation as measure by the CPI may rise over the shorter term to as much as 6% (due to the anniversary of last fall’s oil price decline), we do not expect this to be more than a cyclical concern. Money supply growth has been mostly flat since 2005 and the inflation fires had been stoked domestically by the expansion of credit (velocity of money) over this period via our financial system. We do view the current de-leveraging process along with large debt levels, low savings and the continued housing concerns as deflationary. The U.S. is no longer the price setter for commodities as our declining demand in the face of rising prices indicates. That title now belongs to the developing world. However, we anticipate slowing emerging market economies to reduce pressure on commodity prices and in turn lower U.S. inflation via imports in the latter part of 2008 and into 2009.
Longer term we see many changes with a secular realignment of the global economy continuing. The continued emerging markets growth will spur the need for higher wages, greater domestic consumption and social spending. This in turn will have a modest secular increase in inflation and downward pressure on profit margins in developed nations. As our banking system comes under increased regulation and more stringent lending, a protracted unwinding of a multi-decade period of asset-based spending is a high probability.
Our continued focus on high quality companies that can continue to grow their earnings and dividends is especially critical during challenging times such as these. In the last year alone six of the largest Wall Street investment banks have combined to write off more than 50% of the total profits they earned during 2004-2007 and 17 of the 20 companies in the S&P 500 Financial index have cut their dividends. This is the antithesis or what we look for at Coho Partners. Over the same time period, the vast majority of our companies have shown improved earnings. Moreover, so far in calendar 2008, roughly 70% of our holdings have already increased their dividends and we anticipate that by year end virtually all will have done the same with the average increase exceeding 10%. In the face of the current market and economic turmoil, we continue to look for and find companies possessing these characteristics.
