Seeds of a Recovery?

The initial first-quarter GDP reported was greeted with a great amount of fanfare, despite a terrible headline number. Though the economy contracted at a 6.1% pace - marking the first time we have booked back to back quarters of down 6% or more since the end of WWII - some of the details in the report showed reasons for optimism.

As an investor, I realize that you are less concerned with the details that economists seemingly over-analyze and more concerned with what the report means to your portfolio. So, today, I’m going to show you where some of the investment opportunities and risks lie in the current environment.

Consumers Opened Their Wallets

The biggest positive surprise in the report was that Personal Consumption Expenditures ("PCE") actually contributed 1.50 points to GDP.

Clearly, in the first quarter, consumers took advantage of discounted prices. The much higher than expected PCE is part of the reason that the retailers and restaurants have been earning so much more than was expected. Almost every retailer and restaurant in the S&P 500 that has reported so far has come in with higher than expected earnings. Given the need to rebuild savings and the mounting levels of unemployment, I am skeptical that the strong PCE levels can be sustained.

Inventory Levels Plunged

On a forward-looking basis, perhaps the best part of the GDP report was that inventory investment subtracted 2.79 points from growth (versus -0.11 in Q4). Large inventory draw downs in one quarter have a tendency to be reversed in the next quarter. When the shelves are bare, people start to order more to restock them, causing output to rebound.

The destocking of inventories has contributed to the cash flow of the retailers, but the restocking will reverse that. On the other hand, restocking the shelves will increase orders for manufacturers, both here and abroad. The report is not detailed enough to say where exactly the biggest inventory draw downs were, so it does not give that much guidance as to which manufacturers might benefit the most from the restocking.

A Bad Trend for Equipment Makers and Software Developers

Essentially all investment in the real economy, both fixed and inventory, residential and non-residential, came to a screeching halt in the quarter. While ugly contributions from inventories are a good thing, the same cannot be said about fixed investments. There bad is bad, and this was real bad.

Fixed investments, particularly non-residential fixed investment is what drives increases in the productive capacity of the economy (along with investments in education which is counted as part of PCE and state & local spending). In other words, it is the engine of future growth, not just a part of the current growth. The stunning declines in all forms of fixed investment mean that businesses are in effect eating their seed corn. However, given the huge amount of idle capacity in the economy right now, it is easy to understand why businesses are cutting back.

Until we see a large rebound in capacity utilization, it is unlikely that businesses will start to spend more for equipment and software. Capacity utilization is at a post WWII low, and is below 70% for the first time since it has been tracked. As a general rule of thumb, 80% is normal, 85% is a boom and 75% is a nasty recession. This is obviously not good news for more traditional equipment manufacturers, such as Parker-Hannifin (PH) or Ingersoll-Rand (IR), nor is it good news for software firms like Microsoft (MSFT) or Oracle (ORCL).

Expect this part of the economy to remain weak for at least several more quarters. This is particularly true on the structures side. I suspect that most of the spending we did see in the quarter was simply finishing off projects that were started in earlier quarters. The Commercial Real Estate ("CRE") bust is just getting started and will last at least another year. Investment in structures has only started to decline and was a major contributor to GDP up until the third quarter of last year.

This means that demand for the basic materials that go into building large structures, steel, glass and cement, are likely to remain depressed for at least the next year. Not exactly bullish for Nucor (NUE), PPG Industries (PPG) or Cemex (CX).

Vacancy rates going up and effective rents are going down in almost all areas of commercial real estate. I would be very cautious about investing in REITs here. Commercial foreclosures are going to become a much bigger story over the next year. This will hurt the banks, particularly the mid-sized banks (between $1 and $10 billion in assets). The Wall Street titans do have as much exposure (relative to their overall size) to CRE.

The decline in equipment and software has been unusually steep (it was down 33.8% in the first quarter, following a 28.1% decline in the fourth quarter), and it now represents the smallest share of the economy since the mid 1960s. The decline will probably continue, but is may be at a slower rate in coming quarters.

At some point it will turn up again since equipment wears out and software becomes obsolete. I would focus on those equipment makers where the product most obviously decays over time. For example, spending on transportation equipment was 61% lower in the first quarter of 2009 than it was a year ago. This means that there is some potential pent up demand for firms like PACCAR (PCAR) that is building up.

Residential Investment Still Slumping

Perhaps the most surprising number on the downside in fixed investment was the subtraction of 1.36 points from Residential Investment ("RI"). RI is now only 2.7% of GDP, down from a peak of 6.3% in the Q4 of 2005.

RI turning up is a classic signal that a recession is ending, and there is no sign that it is happening yet, but it seems unlikely that RI will fall to zero. Normally the rebound is very sharp, but I have my doubts that it will be so this time around, given the huge inventory of unsold houses, both new and used and the second wave of foreclosures that is starting to crash upon the shore.

I have long been very bearish on the Homebuilders like D.R. Horton (DHI), however at this point I am becoming more neutral since it is hard to see how much lower residential investment can go as a percentage of GDP. That does not mean that I expect a big rebound anytime soon, but the worst of that particular storm may have passed.

Net exports helped prevent the quarter from being a total disaster, adding 1.99 points to growth. This was however not due to a surge of exports, but rather a collapse of imports.

The decline in imports was stunning, contributing 6.05 points to growth. (Imports are a subtraction from GDP, so when they fall GDP goes up). Put another way, if we had continued to import in the first quarter at the rate we had in the fourth quarter, then GDP would have crashed at an annualized rate of over 12% in the first quarter.

When inventories are drawn down, we buy less from China as well as less from domestic manufacturers. In case you have not noticed a lot of the stuff on the shelves of Wal-Mart Stores (WMT) and Target (TGT) comes from overseas. If PCE can continue its surprising strength going forward, the decline in imports is unlikely to continue. That, however, is a big IF.

No industry is more exposed to a decline in world trade more than the shipping industry. There are lots of ships that were ordered during the boom times that are just putting to sea. It will be a while before enough ships are scrapped to bring capacity into line with demand, thus keeping shipping rates very low. Ships represent very large capital investments and having them idle is very expensive. While the group has been hammered, I would still avoid those firms for anything but a very short term trade.

Understand that the longest recession since the Great Depression is not over by a long shot, but it will not last forever. We are past the steepest rate of decline, but are still going down.

The U.S. consumer is once again proving to be the Rasputin of the world economy, he is very hard to kill thanks, in part, due to some extraordinary measures taken by Dr. Bernanke. This is probably the key reason for the better than expected PCE numbers.

As I said earlier this week, there are still very substantial risks out there that could cause the rate of decline to accelerate again, most notably the prospect of long messy bankruptcies in Detroit, and the worst fears of the Flu epidemic coming true (almost impossible to tell at this point). However, the seeds of recovery have been planted. Inventory will need to be restocked and eventually businesses will have to replace some of their equipment and will start to spend again. However, I would not expect a bumper crop from those seeds. The recovery, when it comes, is likely to be very anemic.

Best of Luck,
Dirk van Dijk, CFA
Director of Research,
Zacks Equity Research

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