Market Recap: Let the Spending Cuts Begin

Shawn Narancich, CFA, VP Research
Ferguson Wellman,

Let the Spending Cuts Begin

Unexpectedly mixed election results in Italy forced investors to confront the consequences of a divided government in this important southern European economy, creating turbulence in global equity markets and sending risk-averse money back to the safety of U.S. Treasury bonds. Add today’s implementation of $85 billion in sequestered federal spending cuts to an equation that already factors in higher payroll taxes and income taxes on the wealthy, and one has to wonder if stocks will be able to hold their gains for the year. In economic terms, this triple threat represents a formidable headwind equal to about 1.5 percent of U.S. GDP, or roughly 75 pecent of total economic growth produced by our economy last year.

Puts and Takes
Against a backdrop of U.S.-style austerity, housing and auto production have become key growth engines for the economy, and with the wealth effect from a stock market near record highs, it’s hard to imagine the economy falling back into recession anytime soon. To wit, the government revised away its initial reading of negative 0.1 percent GDP growth in Q4, as a smaller import bill and greater than originally projected exports reduced the net foreign trade drag. Since businesses drew down inventories in the fourth quarter, our economy in early 2013 should get a boost from inventory rebuilds, not to mention the reconstruction efforts from Hurricane Sandy. Meanwhile, manufacturing is a stronger positive, with the monthly PMI Index for February signaling rising orders, production, and employment. All told, we believe the near stagnant 0.1 percent fourth quarter growth should morph into something closer to 2 percent GDP expansion in the first quarter of 2013. However, with fiscal headwinds increasing, investors are correct to question how much better growth could get this year.

From Bad to Worse
When we wrote about JC Penney’s new boss and retail model last year, we questioned how successful Ron Johnson’s radical makeover of the woebegone American retailing icon would be. If yesterday’s quarterly results are any indication, Americans are in no mood to experience his brand of retailing. The stock cratered 17 percent on news that sales fell even more, declining at an accelerating rate of 28 percent in the company’s most important quarter. Not only has new management failed to deliver the turnaround that was promised to have been occurring by now, but its strategy of shunning “the deal” is spilling an increasing amount of red ink on Penney’s income statement. All of a sudden, credit ratings agencies are on the scene questioning the company’s ongoing ability to service its $3 billion of debt, and management is changing course, promising to offer coupons and sales again.

A Contrast in Styles. . .and Results
To all of which Macy’s responds by saying, thank you! The company behind the bright red star posted better than expected 18 percent earnings growth for Q4 and guided analysts to expect current year earnings ahead of estimates. While some customers may get weary of Macy’s seemingly never-ending sales promotions and one-day only coupons, the proof is at the cash register – and Macy’s is clearly winning. As for investors, the starkest contrast between the strategies and results of JC Penney and Macy’s is the relative stock performance of these competitors – Macy’s up 5 percent over the past year while JCP has plummeted 55 percent.

With major retailers having now reported their numbers, fourth quarter earnings season is complete. To gauge the health of their companies, investors will now turn to the forum of industry conferences and the ongoing drumbeat of economic reports, headlined next week by Friday’s February employment report.

Our Takeaways from the Week

  • Stocks treaded water as risks emanating from Europe re-emerged
  • The retailers wrapped up a long earnings season with mixed results

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