Glass Half Full, but Cracked
Investors welcomed the first full week of second quarter earnings season with surprising enthusiasm, rallying stocks for modest gains despite finishing the week on a sour note. Could it really be such a surprise that Spanish officials now foresee recession in their austerity-wracked economy next year? News that Europe formally agreed upon the 100 billion euro Spanish bank bailout was not enough to calm bond market nerves there, as the sovereign 10-year bond encountered selling pressure following a weak Spanish auction Thursday. Yields came to rest at a robust 7.2 percent for the week, a level deemed unsustainable given Spain’s large debt load and ongoing deficits. Absent these headlines Friday, Europe was refreshingly quiet this week as investors turned their full attention to earnings.
Sell the Rumor, Buy the News?
With approximately one quarter of the S&P 500 having reported earnings so far, what stands out is not that over 60 percent of reporting companies have exceeded estimates, but the reaction to earnings reports and forecasts that in periods past would have resulted in selling pressure. Industrial conglomerate Honeywell is a case in point; while reporting earnings that beat estimates, sales missed expectations and management reduced revenue forecasts for the year in acknowledgement of a slower global economy. The result? The stock gained nearly 7 percent on an encouraging outlook for margins and relief that the currency hit from dollar strength wasn’t worse. In technology, Intel provided another example of this same dynamic as it reduced sales forecasts following its report of flat earnings, with the stock responding positively afterward. While it’s true that in both these cases the stocks were off 10 to 12 percent from recent highs prior to reporting, our preliminary conclusion is that investors are taking a glass-half-full approach to this earnings season. And yes, once again, companies appear to have done a good job of managing analyst expectations prior to reporting. Finally, we suspect that near-record low interest rates are making stocks incrementally more attractive to institutional investors despite retail money that continues to flee domestic equity funds.
The Fed’s Dry Powder
Meanwhile, economic data stateside continues to be problematic. For a third consecutive month, the Commerce Department reported a sequential decline in retail sales, further supporting recent downward revisions to second quarter GDP. Price levels remain benign in the U.S. With headline inflation at 1.7 percent, the Federal Reserve clearly has the cover to boost monetary stimulus if the economy stalls. In testimony to Congress this week, Bernanke acknowledged that more can be done, but failed to signal imminent action amid reports that showed a rebound in industrial production and a rate of new housing starts now at its strongest rate in nearly four years. Whether or not the Fed decides to act again this year, investors are increasingly coming to realize that more monetary stimulus will not have the same efficacy as it did before; with the Federal Funds rate near zero and 30-year mortgage rates approaching 3.5 percent, how much more demand can Bernanke & Co. stimulate with the fiscal cliff threatening domestically and Europe’s debt problems looming like the Sword of Damocles internationally?
With a slow growth economy baked into expectations, benchmark 10-year Treasuries remain well bid, closing the week to yield a paltry 1.46 percent. Earnings season continues at full tilt next week, with the likes of McDonalds, Apple, and AT&T reporting their numbers in a week that will also see the government reporting its first estimate of second quarter GDP.
Our Takeaway from the Week
- A mixed bag of earnings news is being greeted in surprisingly fine fashion against a backdrop of slow economic growth globally and attractive equity valuations