Playing the 2nd Derivative
April 15, 2009
By Richard Berner & Jason Todd, CFA
| New York
The recent improvement in selected US and global data suggests that the worst of the global recession is likely over and that a bottoming process is underway. The equity market has fully embraced the improving second derivative trade and remains in the midst of its strongest rally since the bear market began in October 2007.
We think investors can play the rally, but we remain cautious and look for opportunities to sell. There’s a fair amount of good news in the price, and financial markets are already moving to price in the next step of the recovery phase – that of reflation and economic stabilization. In contrast, we think the global recession has further to run and that the coming recovery will be modest. The breadth, depth and duration of this downturn also raise the potential for head fakes and false dawns on the path to a sustainable upturn that will, in turn, drive bouts of investor optimism and pessimism (see Depth and Breadth Matter, April 6, 2009).
In particular, we remain bearish on earnings. We think that a number of top-line (revenue) and bottom-line (margin) pressures will continue to undermine corporate results, potentially capping near-term upside for the equity market. Revenue growth will remain under pressure from ongoing financial headwinds, inventory levels that are still top-heavy, and a further decline in pricing power. At the other end of the income statement, declining operating and financial leverage and a reversal of low-quality tailwinds, such as inventory revaluation, USD translation gains, pension gains and share count reduction, are squeezing profit margins – a double threat to corporate earnings.
That the equity market has reacted to an improving ‘second derivative’ is not a concern. However, with the market up 28% from the low, it has already moved a long way towards pricing in a better 2H09 growth trajectory (or, thought of differently, pricing out the premium for downside tail risk) and is now at risk of taking for granted the timing, speed and magnitude of any recovery.
Deep output recessions often signal that inventory liquidation will turn to accumulation, promoting snapbacks in output and eventually hiring. We do not believe that this will be the case in the current cycle. Corporate America has not cut production excessively in relation to the actual level of demand, and we think that the ongoing credit crunch will delay a recovery in both sales (pent-up demand) and thus hiring. Ultimately, the sustainability of equity gains will be determined by how much end-user demand (especially real consumer spending) recovers, and we think this rebound will be modest. (see Perfect Consumer Storm Not Over, March 31, 2009).
Top-Line Revenue Growth – A Volume and Price Collapse
We see three factors limiting the potential for upside surprise to revenue growth estimates through 2009.
First, the ‘adverse feedback loop’ from a weak economy to credit quality and back is limiting the net benefits from policy efforts to restart securitization markets and ease the credit crunch. That headwind will cap consumer spending growth, as well as the benefits from lower mortgage rates on housing demand. And it will depress capital spending and limit the ability of stressed state and local governments to finance current services.
Second, a contracting global economy will hobble US exports, which so often in the past have provided a cushion of support for US growth when the US business cycle and those abroad were out of sync. It’s worth noting that, with 38% of US earnings coming from overseas affiliates, the global recession is also hammering overseas bottom-line results.
Third, with operating rates at record lows and slack in the economy continuing to grow, disinflationary forces will contain nominal revenues long after the economy begins to turn up.
Corporate Profit Margins – Pressures Prevalent
Equity investors may already be prepared to pay for the next earnings upswing, but we think that profit margins will continue to come under pressure from a combination of forces that are unlikely to dissipate quickly.
Global recession together with high leverage (operating and financial) are creating a one-two punch for margins, which are in decline but remain elevated on a historical basis. We doubt that the full effect of declining operating leverage and plunging rates of capacity utilization – which are reducing pricing power – has completely worked its way through to the bottom line, especially as margins for a number of sectors (Energy, Industrials and Technology) were still close to peak only six months ago.
We see additional headwinds for margins coming from a variety of sources: 1) A reversal of inventory revaluation gains, where plunging prices are depressing the book value of inventories acquired around the peak of the global boom, which we estimate will subtract 150bp from profits in 2009; 2) a stronger USD (up 21% 4Q over 4Q), reducing translation gains for foreign generated earnings, which stood at an all-time peak of 38% in 4Q08; 3) reversal of share count reduction, which added 250bp to earnings in 2006, 300bp in 2007 and 87bp in 2008, as both the cost and ease of financial leverage (issuing debt and buying back stock) reverse; and 4) rising pension costs as a deterioration in the funded status of pension plans draws greater cash contributions and as falling plan assets provide a smaller expected return boost to the income statement (we estimate this at 300bp in 2009) .
Although margins are receiving some relief from falling input costs (particularly for raw materials – commodities and energy), lower imported goods prices, and a steeper yield curve, these are only minor offsets in comparison to the combination of headwinds discussed above.
Where Are Earnings Most at Risk?
Sectors we believe are most vulnerable to earnings disappointment and lower guidance include:
1. Technology (Hardware and Semis) – Semi stocks have risen more than 30% from trough in the recent rally. Inventories in the supply chain remain elevated, valuations rich, and we are wary of underestimating the scope of demand improvement necessary to take these stocks from an inventory rebuild rally to one supported by broadening fundamentals. We think the market is now discounting a best-case scenario of inventory replenishment starting in 2H09. This appears unlikely, given that Semis’ forward inventory days are at the highest level ever. A similar situation occurred in 2001 when the SOX rallied 71% and analysts revised estimates upwards as they mistook orders to restock as real demand.
We are equally concerned about the rally in many Hardware names, where utilization rates remain weak and pricing and demand visibility poor (we have always bought Tech when utilization rates are rising, and sold Tech when utilization is falling). Historically, corporate earnings have led capex, and despite the limited capacity growth and broad underinvestment heading into the current recession, we think the risk of demand surprising on the upside (either corporate or consumer) is low.
2. Industrials (Cap Goods, Selected Transport, Distributors) – Declines in commercial construction and capex-related spending have been more severe than anticipated, and earnings will not rebound as quickly here as they do for shorter-duration cyclicals. We see the potential for significant earnings disappointment in coming quarters as margins come under significant volume and pricing pressure (as of 3Q09, the sector was still close to all-time peak margins and earnings).
In addition, many industrial names have rallied strongly on the potential for inventory rebuild. However, recent company commentary indicates that inventory destocking in the channel shows no signs of abating. Moreover, inventory destocking is occurring in both industrial verticals and non-residential construction verticals. Typical re-stocking ahead of spring/summer construction seasons is not occurring. Further, at the manufacturer level we expect that widespread capacity reductions and an aggressive focus on working capital will also lead to reduced inventory levels.
3. Materials (Metals & Mining) – Materials rallied almost 38% in March, even though earnings visibility remains poor. We see continued pressures on commodity prices as demand remains weak and stock relatively high. Capex has broadly halved, and while these cuts have been earlier than in past downturns, inventory build may weigh on base metal prices in the near term.
We do not think real demand recovery in excess of a re-stocking boost will challenge industry capacity over coming quarters. If demand recovery proves stronger than expected, copper is the most likely to replicate the price strength prior to the downturn. Steel and aluminum prices will likely respond in this scenario, but are less likely to benefit from excess pricing power due to more significant capacity overhang. Steel is in a relatively stronger position than aluminum due to low systemic inventory.
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April 15, 2009
By Marcelo Carvalho
| Sao Paolo
As the economy sinks into recession, labor markets will likely worsen further. Brazil’s labor markets have just started to deteriorate. Given time lags, the unemployment rate looks likely to climb to double-digits this year. The good news: Inflation is low and therefore will not erode wages so much this time, unlike in past episodes. The bad news: Job losses will likely hurt total wage earnings. Labor market worsening is most visible in industry so far, but seems likely to spread to other sectors too. Formal jobs look particularly vulnerable.
In turn, deteriorating labor markets should provide a negative feedback loop into consumer confidence and consumption. Widening labor market slack will also bloat delinquency ratios and erode tax revenues, in our view.
All You Need Is Jobs
The unemployment rate looks set to jump to double-digits. Brazil’s unemployment rate has trended steadily lower over the last several years of global abundance – from an annual average peak of 12% back in 2003 all the way down to an average of 8% in 2008. However, as the economy dips into recession, the unemployment rate should jump in coming quarters. We expect an average unemployment rate of around 11% in 2009. If we are right about the magnitude of the recession, the headline unemployment rate could climb to the 12-13% range later in the year.
Labor market trends have started to turn down already. The unemployment rate has already begun to worsen, increasing to 8.2% (seasonally adjusted) on average in the three months through February 2009, from an average low of 7.5% in the three months through September 2008.
Brazil’s economy usually needs to grow in the 2-4% range in order to keep the unemployment rate stable by absorbing new entrants to the system, judging by recent history. Labor markets typically lag behind the business cycle, with a time lag of about one quarter in Brazil’s case. Looking ahead, labor market trends look bound to worsen substantially in coming months.
Look for outright job losses ahead. Employment trends look significantly correlated with swings in industrial production, with a time lag of about three months. As industrial production sinks into unprecedented weakness, employment expansion is set to fall into outright negative territory in the coming months. Employment growth has been around the 2-3% range in recent years, but we see it falling to -2% in 2009.
Meanwhile, we assume that the labor force continues to expand, at around 1% per year – not far from the average pace seen in recent years – as new job seekers continue to enter the market. The labor force is subject to opposing forces in a business cycle downturn. On the one hand, discouraged workers may give up looking for jobs and simply leave the labor market altogether. On the other hand, rising unemployment and shrinking household earnings may force more family members to look for jobs.
Men at Work?
The good news: Inflation should remain subdued and therefore will not erode average real wages as severely as in the latest turmoil. Back in 2002-03, sharp currency devaluation sent consumer price inflation into double-digits. In turn, the jump in inflation quickly sapped average real wages, while nominal wage gains flattened out. Now, average nominal wage gains will likely slow to a crawl once again, but inflation is proving much more benign. Real average wage earnings therefore should fall less than in 2003. That said, job rotation and more flexible labor arrangements in some cases threaten to push average nominal wages down.
The bad news: Total wage earnings will likely suffer nonetheless. While real average wage earnings (per worker) should prove resilient, the total number of employed workers will likely take a hit. In fact, if employers care about their total payroll bill, it is conceivable that the slow adjustment in prices might force a larger adjustment in quantities. That is, in the absence of wage-eroding inflation, would employers then try to compensate by cutting jobs more than otherwise? In all, we assume that total real wage earnings come down in 2009, although by less than in the 2003 cycle.
Labor market losses in industry will likely spread to other sectors. Industry is often the most cyclical and leading sector of the economy. Growth in average real wage earnings in industry fell from 6.6%Y last September (before the global turmoil hit Brazil with full force) to -3.0%Y in February 2009. By contrast, real average gains in wage earnings in February were still positive in other sectors, including construction (0.5%Y), commerce (4.3%Y), services (8.7%Y) and education (5.7%Y). For the economy as a whole, real wage earnings growth slowed from 6.4%Y in September 2008 to 4.6%Y in February.
What about the minimum wage? The government has granted significant increases in the nominal wage over the last several years. The latest nominal annual increase was 12%, effective as of February 2009. About a quarter of workers in Brazil seem to earn less than or equal to the minimum wage, judging from 2007 data. The minimum wage is relevant for social security outlays and for the lower end of the income spectrum. However, changes in the minimum wage do not seem a major driver of overall labor market trends in Brazil.
Private sector labor markets dominate public sector job trends. One commonly heard argument is that stable public sector jobs could save the day. We do not count on that. Public sector employment represents only about 11% of total jobs in Brazil – including federal, state and local government employees, besides employees in state-owned enterprises. That ratio does not appear particularly high by international standards (see “Emprego Público no Brasil: Comparação Internacional e Evolução”, Comunicado da Presidência número 19, Instituto de Pesquisa Econômica Aplicada (IPEA), March 30, 2009).
The growth downturn will likely hurt the recent ‘formalization’ of Brazil’s labor markets. During the last several years of global abundance, there has been a clear migration towards the formal sector of the economy. The share of workers without proper formal registration has shrunk – from almost a quarter of the total a few years ago to below 20% by early 2009. However, the ongoing growth recession is likely to slow this trend at best – or even reverse it altogether. As cash-strapped firms scramble to cut costs, employers might turn to (less expensive) informal workers.
Recent formal job losses send a worrisome message. Considering the high costs involved in firing workers in Brazil, the plunge in formal employment in recent months (CAGED data) indicates the pessimism of employers about the economy’s outlook. Net formal hiring plunged into negative terrain last December for the first time in about a decade (seasonally adjusted). January and February formal labor numbers look less dramatic, but remain depressed by historical standards.
In turn, labor market deterioration should carry negative ripple effects. First, it will likely hurt domestic demand. Increasing unemployment, rising job insecurity and shrinking wage earnings promise to dent consumer confidence and private sector consumption. In fact, labor markets are a key ingredient in our growth forecast. Labor markets have just started to deteriorate in Brazil. Given time lags, the worst is yet to come. For their part, worsening labor markets will entail a negative feedback loop for domestic demand, in our view.
Second, credit quality is set to deteriorate amid rising unemployment. The overall delinquency ratio facing the banking system might easily double this year, from the average 3% mark seen in 2008, for the system as a whole. There are already first signs of deterioration in recent data. No wonder banks have turned more cautious in domestic lending.
Third, labor-related tax revenues should fall. In particular, social security contributions have increased substantially in recent years, on the heels of rising formal employment. Unhappily, weaker labor tax revenues might expose remaining long-term structural challenges facing Brazil’s pay-as-you-go social security system.
Growth recession hurts labor markets – with a lag. Brazil’s unemployment rate has just started to worsen. It will likely jump to double-digits this year. Despite lower inflation, job losses should hurt total real wage earnings. Industrial employment and formal jobs are most vulnerable, but weakness will likely spread to other sectors too. In turn, weaker labor markets should provide a negative feedback loop into consumer confidence and consumption.
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