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How Long Can Consumers Hold On?

Inflation pressures either moderated in August or reached an almost 15-year high, depending what is focused on. Since the Federal Reserve let everyone know that it is focusing on the "core rate," bond traders welcomed the news that core PPI was flat in August compared to the 0.4% increase last month and a 0.1% increase predicted by economists. Including food and energy costs, producer prices increased 0.6%, which was on top of a 1.0% gain last month. On a year-over-year basis, producer prices have increased 5.1%, the fastest pace since December 1990.

Industrial Production rose in August by 0.1%, inline with the increase last month, but lower than the 0.3% increase economists forecasted. Compared to last year, industrial production was up 3.1% for the third consecutive month. Capacity utilization was unchanged at 79.8%. This is further evidence that the manufacturing sector has leveled out recently after rebounding after the recession.

The headlines for the August retail sales report painted a grim picture on the strength of American consumers. However, it didn't paint an accurate one either. August sales dropped 2.1%, which was the second largest drop since the data series was changed in 1993. The drop was only because of the huge auto sales last month. Excluding autos sales increased 1.0%. On a year-over-year basis, retail sales excluding autos increased 10.7%. This was the highest since the record set in February 2000, which is the highest increase since at least 1993. Everyone has discussed how high gas prices are eating into discretionary spending. This report shows that in August, sales at gasoline stations rose by $8.9 billion or 31% from last year. While this is a large gain, in fact it is the largest year-over-year gain in gasoline sales, total retail spending rose by $31.5 billion. Department stores were the only segment in which sales declined on a year-over-year basis. It appears that in aggregate, consumers have not altered their budget because of higher gas prices.

Even though total sales have not been adversely impacted by higher gasoline prices, companies have continued to cite it as a reason for their lackluster performance. Most of these companies have catered to lower income customers. Today, CEC Entertainment, the company behind the Chuck E. Cheese restaurant chain, announced that its same restaurant sales for the first ten weeks of the quarter were down 5%. The company also cut third quarter guidance to $0.42-$0.47 from $0.56-$0.61 is guided to in July. The company cited the hurricane impact and higher gasoline prices. Instead of saying that lower income customers were feeling the pinch more, CEC said the "effect of high gasoline prices on disposable consumer income has been particularly hard on families with young children."

Best Buy reported earnings that were one penny below estimates, but at the high end of management guidance. Same store sales increased 3.5%, which was a little lower than the 4.0% comps most analysts were expecting. The company also faced higher costs, which it attributed to the costs of rolling out its new format and ramping up its service business. Investors were spooked by the fact the Best Buy has low visibility over the next several months. Due to the uncertainty of consumers, the company reduced its guidance to $0.28 - $0.32 per share. Wall Street followed suit, lowering estimates for the third and fourth quarters.

There is little doubt that the strong housing market has buoyed consumer spending. On Wednesday, M.D.C. Holdings, one of the nation's largest homebuilders, said it may miss analyst's forecasts for second quarter earnings because of construction delays. The company cited labor and material shortages in Arizona along with delays in electricity connections in Nevada. The company said these are simply delays and will close in the fourth quarter. This follows lower than expected earnings from Hovnanian Enterprises last week. The company was emphatic that it performed better than its guidance, but Wall Street analysts were setting unrealistic estimates. Also last week, The Federal Reserve released its latest Beige Book. By all accounts, the economy was expanding prior to Hurricane Katrina hitting at the end of August. David Rosenberg, chief strategist at Merrill Lynch, noted that in the latest Beige Book, ten out of the twelve districts noted a slowing in residential real estate.

Newspaper companies have reported weak results for several quarters. Results have not gotten better. This week, Knight Ridder and Tribune announced that revenues declined in August. At Tribune, advertising revenue increased 0.9%. Strength in classified advertising offset weakness in retail and national advertising. Classified advertising increased 5.9% mainly due to a 14% jump in help wanted combined with a 12% gain in real estate. Automotive classified dropped 4%. Auto advertising was also weak on the national level. National adverting continued to be the weakest segment, dropping 5.5%. Strength in financial and media advertising was more than offset by weakness in Strength in home improvement, education and restaurants didn't make up for the weakness in technology, movie, transportation, and autos. Retail advertising experienced declines in food & drug stores, electronics, department stores and furniture. Circulation continues to drop. Circulation revenues dropped 8.6% in August due to a combination of volume and discounting.

Advertising revenue at Knight Ridder increased 1.2%, but its results were similar to Tribune's. National was the weakest segment and classified was the strongest. Within classified, help wanted jumped 15.8% and real estate was up 8.9%. Auto declined 9.6%. Not only has revenue matched expectations, but costs have been higher as well. The company said that its newsprint cost increased 9.1%. These events caused the company to lower its guidance for the third quarter. The company now expects earnings per share will drop 20% from last year's levels. Analysts were expecting a drop of only 5%.

The quickest read on consumers after the hurricane came from the ABC Consumer Confidence survey. This weekly survey declined three points the week after Katrina, but the decline was mostly in the response to the state of the economy. The index measuring buying climate did not budge. This week, the index plunged five points to -20, the lowest since March 15, 2004. Additionally, all three indexes dropped with the buying climate index dropping eight points to -36, which was the lowest reading since November 1993.

The focus next week will be the FOMC meeting on Tuesday. The recent economic data indicates that the economy was strong prior to the hurricane. Traders have noted this as well. October fed fund futures closed to yield 3.71% on Wednesday, indicating the chance of another 25 basis point hike most likely.

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