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Is Growth Waning?


Retail sales fell 0.3% in August according to the report published by the Commerce Department this week. The drop was due to a 1.9% drop in auto sales. Retail sales excluding auto sales increased 0.2% and have increased 4.6% year-over-year, the lowest since June 2003. Earlier this month, the ICSC reported that chain store sales increased 1.1%, which was also the lowest year-over-year growth since June 2003. The Commerce Department breaks out sales by category. Clothing stores (-0.4%) and general merchandisers (+1.4%) posted the weakest year-over-year growth in August. Both were the lowest growth in over a year. Building materials (+15.3%) and gas stations (+14.4%) both had double digit gains.

Stagnant auto sales have caused the automakers to curtail production. After reporting August sales data, both Ford and GM announced that fourth quarter production would be lower than last year. This will not help the manufacturing sector that has been steadily expanding, but is currently showing signs that growth is moderating. Industrial production increased only 0.1% in August, which was lower than the 0.5% increase economists forecasted. Over the past year, industrial production, as measured by the Federal Reserve has increased by 5.2% and eclipsed the previous peak reached in 2000 two months ago. However, production has been essentially flat since May this year along with capacity utilization, which has hovered just below the recent peak reached in May at 77.4%. Utilization remains far below the levels prior to the recession that were in the 83% range.

The Kansas City Fed Manufacturing Survey increased 4 points from July to August to 50. (Unlike the ISM surveys, which use 50 as the increasing/decreasing hurdle, the Fed surveys use zero. Also for some reason the headline number from the KC Fed survey is based on year-over-year changes not month over month. The others are month-over-month.) This is only one point from the record high reached in June. The shipments component reached a new high of 55, jumping six points from July, which was also the previous high water mark and new orders increased by one to 52, tying the previous record high set in June. This was similar to the Richmond Manufacturing survey that said shipments jumped 12 points to 18 in August. The Empire State Manufacturing survey jumped from 13.2 in August to 28.3 this month. New orders, shipments and unfilled orders all rose significantly.

These surveys also indicate that prices paid have continued to rise faster than the price they receive. All three surveys showed that the index tracing prices paid is far higher than the prices received. Looking at the Kansas City survey, prices paid has been fluctuating in the 70s and 80s since April, while prices received have mainly been confined to the 30s, with one month registering 42. Expectations call for the trend to continue as the six-month outlook for prices paid was 55 and prices received was 20.

Steel companies would like to help those forecasts come true. Last week, Timken announced it was increasing prices for all of its steel products by $60 per ton. This week, International Steel Group announced it expects steel prices to increase by $75 sequentially in the third quarter. This is $25 higher than previous guidance. The company forecasted that the average price and shipments next year will be higher than the average price this year. The company expects contract renewals to be up 20-25%. There is hope that steel price is peaking. The company expects that contracts will be renewed below the current spot price. Last year, contract pricing was above spot price.

A few months ago, I cited a research report from UBS that said if steel prices remained where they were, the increase in steel would cost the industry between $3 and $4 billion. This exceeds the cumulative profits of the nine auto suppliers the firm covers. At the time, analysts expected steel prices to decline. Instead they have increased further.

While rising steel prices will wreck havoc on manufacturing earnings. Rising health care cost is affecting the entire economy. A report was published last week by the Kaiser Family Foundation in conjunction with the Health Research and Educational Trust and found that premiums increased 11.2% to $9,950 fro a family of four. Additionally, fewer companies are offering health care benefits. Only 63% of employers offered benefits compared to 68% in 2001. Most of the decrease has come from small employers Premiums for preferred provider organizations (PPO), the most popular type of plan, increased to $10,217 per family. A LA Times article quoted a GM spokesman saying that, "This system is broken. To a certain extent, we can try to control costs with various programs, but at the end of the day, we need the input and support of the government to make reforms here." The article said that GM will spend over $5 billion this year on health care, or roughly $1,400 per vehicle produced.

There are several indications that the recovery that started in x, has run its course. Year-over-year growth rates have started to stagnate. It is difficult to characterize the economy as weak since there is economic growth and it is beginning to level off at such an elevated level. This lower economic growth rate will eventually work its way into corporate earnings. We have detailed how earnings growth is expected to slow during the second-half of the year as well as next year. Currently, according to First Call analysts expect earnings to grow by 14.8% in the third quarter, 15.7% in the fourth quarter and only 7.5% in the first quarter of 2005. For the full year 2005, analysts expect growth to be 10.1%, far lower than the 19.1% increase this year. One of the more extreme forecasts for earnings growth, at least for a Wall Street strategist, comes from Ed Keon at Prudential Securities. Ed Keon, who took the place of the departing Ed Yardeni, wrote this week that he expects S&P 500 earnings to be $64 per share this year, but only $65 per share in 2005. Additionally, Keon does not think the low growth period will be confined to next year. Among the reasons he thinks earnings growth will close to non-existent, is the fact that corporate profits as a percent of GDP is at an all-time high of 7.7%. This is almost 200 basis points higher than the past 55-year average of 5.8%. Since he is a big fan of mean reversion, he forecasts that profit margin will revert toward the mean. In order for this to happen, profit growth has to be lower than GDP growth. While investors are expecting earnings growth to decelerate, it is highly doubtful that investors are expecting low single-digit or zero growth over the next few years.

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