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Starting to Overheat


Over the past couple months the majority of the economic data has indicated that the economy is growing rapidly. The back-to-school season appears to have lifted the economy to even faster growth. In fact, during the past couple of weeks economists have raised their third quarter GDP estimates to 5.5% from 5.2% just a few weeks ago. There are quite a few economists with estimates over 6%. Retail sales during August and September were very good. On Wednesday, the Commerce Department released that September retail sales grew 0.3% excluding auto sales. More telling was the revision of August sales from 0.7% to 1.2%. I would not be surprised to see September results similarly revised next month since same store sales as reported by the major retailers were even better than August. The Bank of Tokyo-Mitsubishi calculates that September retail sales rose 5.9%. Just a week earlier, it had estimated sales would only increase 3.5%.

The strength of September retail sales not only surprised the Bank of Tokyo-Mitsubishi, but Wall Street analysts missed forecasting the resurgence in consumer spending as well. On average, the 54 retailers that First Call had an estimate for beat Wall Streets forecast of same store sales by 3.9%. Of these 54 retailers, 44 posted same store sales ahead of expectations by an average of 5.0 percentage points. Only 9 retailers missed analysts' forecasts, but this is more trivialized since they missed by an average of only 0.5 percentage points. First Call's Same Store Sales Index (weighted index) rose 6.1% versus estimates of 4.2%. September marked the fifth consecutive increase in same store sales growth along with the fifth consecutive month beating estimates. Over the past three month results have outpace estimates by 1.3 percentage points, 1.5 p.p, and 1.9 p.p. respectively.

So far the strength has carried into October. Wal-Mart said its same store sales are "rising within its forecast for a gain of as much as 5 percent." Furthermore the world's largest retailer said, "An increase in the number of shoppers made up more than half of the week's sales gain."

Advertising has been picking up over the summer and went into accelerated in September. Dow Jones reported that September advertising volume increased almost 30%. The growth was broad based as the publisher of The Wall Street Journal said it posted positive in every major category (general, technology, finance and classified) for the first time since May 2000. September was substantially stronger than the first two months of the quarter. While September was up almost 30%, July was down 1% and August was up 2%, resulting in a 7% increase for the quarter. This was the first positive quarter of advertising volume in three years. The company was cautious when discussing what the outlook is. The company did say during the Q&A portion of their conference call that 10-11% of the increase in September came from an extra publishing day and a "mega campaign by one advertiser." The positive trend has carried into October, but November and December at this time appear to be flat." The company mentioned that there is little visibility because, "many advertisers are still evaluating and deciding their spending on a month-to-month basis." Results at Gannett were more mixed, but the company experienced a pick up in September. During the conference call the company said it, "posted some of the best numbers in help wanted since the first quarter of this year, and USA TODAY's year-over-year revenue growth in the month was the strongest since January.

Earnings reports have started flowing in, and as anticipated the results are meeting and beating analysts' estimates. Of the 90 S&P 500 companies that have reported, 6.7% have beaten estimates while only 8.9% have fallen short. Additionally, 78% are reporting year-over-year earnings gains which are up 28.8% on a market-cap weighed average. The 19% of companies that are falling short of expectations are missing estimates by 8.5%. One caveat to this is most of these companies that have reported are financial companies, which have been given a license to print money through a steep yield curve.

The Federal Reserve published the latest Beige Book on Wednesday. There were no surprises and it read very similar to the previous release. Consumer spending was strong throughout the country, with federal tax rebate checks being cited as reasons in a few districts. Seven districts reported weakening auto sales, with St. Louis being the only district reporting improvement in sales, with strength led by imports. Manufacturing continues to improve with machine tools mentioned in Atlanta and Chicago, semiconductor producers in San Francisco, and high-tech in Dallas indicating better conditions. Employment continues to be the weakest part of the economy, but five districts have noticed an increase in demand, especially in temporary workers. Six districts mentioned that non-wage growth, mostly health insurance, are increasing and are holding down wage gains or deterring hiring in Atlanta and Dallas respectively. Residential construction is strong, but the commercial real estate market continues to be sluggish. Banks throughout the country reported a "substantial drop-off in refinancing activity since the last report, though there were a few reports of improvement toward the end of September." Several districts report "little change in prices of consumer goods and services, but steep escalation in certain commodity prices."

Now that the economy is clearly recovering, the Fed is shifting the focus to employment. Usually once the economy starting growing the Fed starts increasing interest rates so the economy does not overheat and cause imbalances and inflation. This shift allows the Fed to continue its accommodative monetary policy as long as possible. We are concerned with the repercussions that this will ultimately lead to. The economy is already imbalanced. Manufacturing jobs are disappearing and being replaced with mortgage bankers. Additionally, as mentioned last week, inflation and/or a weaker dollar appear to be natural outcomes under this scenario as well as more and more credit gets created to support consumption. Let me reiterate last week's major point. The economy is growing faster than 5.0%, possible greater than 6.0% and Fed Funds are locked at 1%.

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