15/11/06
Fund Manager Comment for Investment Week
Third quarter US results season is now almost over and US companies have posted another quarter of impressive profit growth. Operating earnings per share for the S&P500 was up 22% compared to the third quarter of 2005, the 18 th consecutive quarter of double digit growth. Third quarter sales grew by 13%. Energy, materials and financials continued to lead the way. However, the US economy is slowing down, impacted by the lagged effect of higher energy and raw material costs and interest rate increases. As a result, expectations for profit growth in the fourth quarter are for a more moderate pace of about 8%.
Macroeconomic data has been pointing towards an imminent slowdown. Housing data has been particularly weak with housing starts dropping 18% compared to last year, existing home sales falling 14% and house prices down 2.2% in September from a year ago. Also, the Institute of Supply Management manufacturing survey reading of 51 for October finished below September's 53 and the year to date average of 55. This suggests slowing activity for the manufacturing sector, albeit not contraction, which would be indicated by a reading below 50. This softness is now showing up in GDP with the provisional estimate for the third quarter being only 1.8% compared to a rate of over 3% earlier in the year.
So far, the corporate sector is only seeing weakness in housing and auto-related areas. For example, homebuilder profits are down about 30% from last year. Home Depot, the home improvement retailer, reported that sales at its stores which have been open at least a year, fell 5%. Machinery manufacturers such as Caterpillar and Ingersoll-Rand saw sales down about 20% for compact equipment used in residential construction. Also, Rockwell Automation sales to the North American auto sector fell by 50%. Other areas of the industrial economy are holding up well with management talking positively about commercial construction, energy, mining and utility end markets.
However, it seems likely that the economic slowdown will broaden out into other areas of manufacturing and services. Early signs of a broader slowdown are showing up in the company surveys produced by ISI, a New York economics research house, and in volumes carried by North American railroad companies. Also, certain industrial companies that report monthly sales and order numbers, are starting to see weakening trends. Emerson orders increased 5-10% during the three month period ended September, slowing for the second straight month. Base sales at Illinois Tool Works were down modestly in September, finishing below the average third quarter gain of 2-3%. Parker Hannifin reported orders up 6% in October, a meaningful deceleration from the 12% average posted year to date. Caterpillar's North American machinery sales fell 3% for the three month period ended September from double digit growth rates earlier in the year. Grainger reported daily sales growth of 6% in September, a noticeable deceleration from August's 10% increase.
A recession is not expected, but noticeable weakness in US activity should be apparent by spring 2007. Macro data suggests a mid-cycle slowdown, not an end to the global business cycle, so earnings growth while decelerating, should remain modestly positive into 2007.
Alan Rowsell, US Industrials Analyst, Standard Life Investments USA
Bull points:
- Corporate profits up 22% in the third quarter.
- Further profit growth of 8% expected in the fourth quarter.
- Expect a mid-cycle slowdown, not a recession.
Bear points:
- Housing and auto sectors are weak.
- Macro data points to weakness spreading.
- Certain industrial companies now seeing deceleration.
First published in Investment Week on 4 December 2006.
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