No Clear Direction Yet

Equity markets took a 1% hit on Tuesday when Cisco, a bellwether of the tech industry, expressed concern over its projected revenues. Investors ignored analysts’ reminders of the recent reports of other large techs which were in sharp contrast to Cisco’s warnings. But investors are concerned over the broader question; will companies be able to grow sales numbers sufficiently in a sub-par economy to sustain record earnings momentum? 

Last month JPMorgan Chase & Co. said that cheap debt and cost-cutting will stop improving earnings. Last week, Citigroup Inc.’s Tobias Levkovich said the slowdown in margin expansion will pressure stocks. But this week, Jonathan Golub of UBS AG said that companies will extend their run of beating analysts’ earnings estimates into June of next year through a combination of continued cost-cutting and modest top-line growth. S&P 500 companies, excluding the financial industry, had an average profit margin of 11% last quarter, the highest since 2005, according to Bloomberg. Golub said “my read is that this thing is going to go much further because company management is looking at the economic backdrop and saying, ‘let’s just keep things a little tighter for a little bit longer.’”

Earnings for the third quarter are estimated to grow by just under 25% without financials (29.6% including financials). For the next three quarters, they are projected to grow 10.2%, 9.2%, and 6.8%. So far companies have handily beat analysts’ projections. Of the 87% of companies reporting so far this quarter, 72% have exceeded their average analyst estimates which makes it the longest streak of more than 70 percent beating predictions in Bloomberg data going back to 1993. S&P 500 earnings since Oct. 7th were 6.9% higher than analysts forecast, the data show.

The government reported that the US trade gap shrank by $44.0 billion which was more than expected as imports dropped and exports gained. Exports improved by .3% percent, following no change in August. Imports in September dipped 1.0% after rebounding 2.0% in August. The rising exports number is good news for manufacturers, but reduced imports reflect lowered expectations and rising commodity prices place further strain on profits. Yet it is still a good sign that equipment investment continues to trend upward.

The weekly jobless claims number reinforced the declining trend which is welcome news. For the November 6th week (free of any influencers) showed that initial claims fell 24,000 to a much lower-than-expected level of 435,000 (the prior week was revised slightly higher to 459,000). The four-week average shows improvement, down 10,000 to 446,500 for a month-to-month improvement of about 15,000.

While the week was light on economic news, there was plenty of G20 rhetoric to fill the void. With all its noise, the group failed to produce any remedy for trade and investment distortions. The two-day meeting in Seoul, Korea was characterized by disagreements over whether Chinese or US policies were more to blame for economic imbalances that endanger the global recovery. China took aim at the Federal Reserve’s monetary easing which placed strains on a currency used for global transactions, and the US’s continued assertion that the Chinese unfairly and intentionally manage their currency to keep the value of their exports cheap relative to those of competing countries. The best the meeting could muster was an agreement to develop early warning indicators to head off economic turmoil.

Global criticism continued this week of the Fed’s decision to buy $600 billion dollars of US Treasuries thereby flooding the economy with dollars. Many see it as a monetization of the massive debt piled up in the name of stimulus and a weak dollar policy that will promote higher US exports. To that end they do think the Fed will be able to boost inflation, which is one of their goals. But they doubt the plan will boost the economy or bring down unemployment.

A presidential panel recently released a draft of their ideas and it is bad news for top earners. The plan would wipe out deductions and investment breaks available to those who make enough money to itemize their taxes. According to the report deductions and breaks such as mortgage interest and lower tax rates for capital gains could be eliminated impacting the top 20% of earners, which roughly translates to households with income of $117,000 or more.

While the political chances of passage for some of the measures are minimal, the plan still provides some indications of where changes are likely to come in tax policy as the government seeks to pay down the massive debt. In their WSJ article on the plan John D. McKinnon and Nick Timiraos point out that the elimination of the so-called tax expenditures, the accumulation of deductions, credits and other tax benefits by individuals and corporations could generate more than $1 trillion a year in revenue.  These gains might enable them to reduce the overall tax brackets.

McKinnon and Timiraos point out that the real-estate industry has repeatedly fended off efforts to curb the mortgage-interest deduction. “But critics see an opening now because the housing bust has raised new questions about government support for home ownership. ‘There is an increasing understanding that single-family housing has been over-subsidized, and that’s to the detriment of the broader economy,’ said Mark Zandi, chief economist at Moody’s Analytics.”

As we look to next year, fog and uncertainly seem to dominate the screen. Will President Obama turn ideologically as Clinton did so effectively to the center or will he continue in the direction set in his first two years? Will the Republican House meet the President and Senate half way to enact legislation to bring clarity and improve predictability from government?

The Deficit Reduction Panel convened by the White House and chaired by Democrat Erskine Bowles, and Republican Alan Simpson released a proposal for deep spending cuts and broad tax changes touching almost every aspect of the federal budget. In presenting their report Erskine Bowles said “I told people in the White House I had spent more time listening to people in the opposition party than they had done as a whole group.” We hope the White House and the Democrats will follow his example and we hope the Republicans will likewise work as hard to find common ground. The time for action is now. As Bowles put it “we just cannot afford to stay on autopilot, and I guarantee if they don’t do it now, five years from now when we look back and the crisis is upon us…people will think, ‘How could we have been so foolish?’”