Reconciling Theories: Expansion vs Contraction

In the now symphonic debate about wether the economy is heading into a double dip recession, which the real bears argue is absurd because we never came out of the last one, many side-liners sit confused swinging their head side to side like at a tennis match.

The expansionists, who temper their view with a “muddle through” or “new normal” sound bite think the market is over reacting because the real economy is going to get through the next year or two O.K. The contractionists on the other hand, whose camp I lean to, believe the markets are telling us something bad (both stocks and bonds), and what they are telling us is that the economy is either on the cusp of or is currently in a recession. Recent economic data supports this thesis but some will accurately argue that the Japan earthquake, hurricane season, and the Euro banking crisis may be misleading us to believe that things are bad.

If this debate ends like many debates that occur in my home, when my wife and I disagree, both sides will probably be proven right to some degree.

The Bloomberg article below describes data from the manufacturing sector that supports the thesis that things are chugging along here in the US. The data below supports the idea that the American manufacturing complex is well and good. In general this all makes sense particularly in light of the erosion of the US Dollar which has made our exports more attractive. And we have seen this show up in trade data as well.

On the flip side, as a percent of GDP manufacturing and industrial production only comprise about 30% of GDP, whereas consumption in the US accounts for 70%. Thus it is possible for the industrial economy to be functioning, feeding American exports while joblessness in the services and construction sectors drag down consumption. Consumption has been further reduced by consumer credit contraction and tighter lending standards.

What does this mean for investors? If some version of this outline is true, and both sides are right then we will probably see a lot of volatility that takes us sideways for a while, in a wide range, until future economic data begins to confirm which side is right.

Of course few argue that the economy is in fact strong. The precariousness of the most optimistic scenario thus leaves us quite vulnerable to more idiosyncratic shocks and policy maneuvers.

From Bloomberg:

No Sign of Recession With Rail Shipments Showing Growth Trend

Sept. 23 (Bloomberg) — Railroads shipments are the highest in almost three years, helping to defy concerns about a double- dip recession.

Total rail volumes excluding grain and coal averaged 381,831 carloads in August, the most since October 2008, according to data from the Association of American Railroads in Washington. These shipments represent the bulk of materials for industrial production, so rising volumes show the economy is still growing, according to Art Hatfield, a transportation analyst in Memphis, Tennessee, at Morgan Keegan & Co.

“We’re not seeing declines in rail volumes that are synonymous with a recession,” Hatfield said. “We remain in a slow growth environment.”

The correlation between the 12-month average of total rail- car loadings excluding grain and coal and the three-month average of the Federal Reserve’s manufacturing industrial- production index is 0.82, according to Bloomberg News calculations. A correlation of 1 would show they move in lockstep, while a value of zero signals no relationship.

Manufacturing output — which makes up 75 percent of all U.S. factory production — climbed 0.5 percent in August, the fourth consecutive increase, according to Fed data released this month.

“Industrial-production growth is slow but positive,” according to Kurt Rankin, an economist at PNC Financial Services Group Inc. in Pittsburgh, who forecasts a 0.3 percent increase in September from August. This indicates the “gradual” U.S. expansion is still in place, he said.

Rising Output

Gross domestic product climbed at a 1.0 percent annual rate in the second quarter, after almost stalling with a 0.4 percent gain from January-March, Commerce Department data show. GDP will rise 1.6 percent this year, according to the median estimate of 63 economists surveyed by Bloomberg.

The order rate for Kennametal Inc., the No. 1 supplier of cutting tools used by manufacturers including Caterpillar Inc. and Boeing Co., increased at a 20 percent annual pace in August, excluding acquisitions, divestitures and workdays, the company said in a Sept. 15 statement. Kennametal’s end markets “continued to reflect strong demand,” and its industrial business showed “ongoing strength,” the company said.

The Latrobe, Pennsylvania-based company is a “good barometer” for industrial production, according to Sheila Kahyaoglu, a New York-based analyst at Credit Suisse Group AG. Kahyaoglu maintains an “outperform” rating on the stock because its order rate, while poised to slow, will continue to grow at a rate faster than consensus forecasts.

Bullish About Manufacturing

Hatfield is bullish about U.S. manufacturing output even amid concerns that the world economy is slowing. The International Monetary Fund cut its forecast for global growth this week, projecting expansion of 4 percent this year, compared with a June forecast of 4.3 percent.

Hatfield maintains “outperform” ratings on Union Pacific Corp., Norfolk Southern Corp. and CSX Corp., the three largest U.S. railroads, because “valuations are attractive given our earnings estimates, which include the impact of slow growth.”

Between March 13, 2009, and July 1, 2011, the Standard & Poor’s Supercomposite Railroads Index — which includes the three companies — rose 200 percent, while the S&P 500 Index grew 77 percent, Bloomberg data show. Since July, the railroads index has fallen 23 percent, compared with the S&P 500’s 14 percent decline.

‘Some Pickup’

The recent underperformance is driven by investor concern about a recession, Hatfield said. The Fed noted in its Sept. 7 Beige Book report that “most” manufacturers were less optimistic than in its July survey. On Sept. 21, Fed policy makers said they expect “some pickup in the pace of recovery over coming quarters,” adding there are “significant downside risks” to their outlook.

Hatfield still projects rail-car shipments will grow in the “low single digits” for the second half of this year, even though third-quarter volumes may be lighter than forecast because of weather-related disruptions, he said.

FedEx Corp., operator of the world’s biggest cargo airline, cut its full-year profit and industrial production forecasts yesterday, as volumes declined amid a slowing economic recovery. The Memphis-based company now projects U.S. output will rise 3.9 percent in 2012, Executive Vice President Michael Glenn said on a conference call. This is down from its previous forecast of 4.3 percent, said Jesse Bunn, a company spokesman.

Consumer sentiment remains the biggest drag on economic improvement, Glenn said. Still, FedEx expects “modest growth to continue.”

No Indication of Declines

Similarly, since reporting quarterly earnings in July, the three largest U.S. railroads haven’t given any indication of a sharp decline in demand similar to 2008 and 2009, when volumes fell as much as 24 percent on an annual basis.

Omaha, Nebraska-based Union Pacific had its strongest weekly volume so far this year — almost 187,000 carloads — prior to Labor Day, Chief Financial Officer Robert Knight said at a Sept. 21 conference hosted by Citigroup Inc. It continues to see “solid demand” across most business segments, including shipments of industrial products, up 8 percent annually as of Sept. 15 for the quarter ending Sept. 30, he said.

Norfolk Southern, based in Norfolk, Virginia, maintains an outlook “which is still upbeat despite some of the macro indicators,” Chief Financial Officer James Squires said at the Citigroup conference on the same date. Total railcar shipments are up about 3 percent on an annual basis so far for the three- month period ending Sept. 30, he said.

‘Doing Okay’

Industrial volumes for Jacksonville, Florida-based CSX have increased about 5 percent since last year through August for the quarter ending Sept. 30, Vice President Fredrik Eliasson said yesterday at the Citigroup conference. Even amid recent “moderating,” the economy continues to grow and the company is “doing okay from a volume perspective,” he said.

Earlier this month, CSX’s Chief Financial Officer Oscar Munoz said he isn’t concerned about “any kind of overarching sort of dire circumstances around the corner,” as there is still a “general level of optimism” among customers and suppliers.

“Sure, things have moderated, but there is no one in that near state of panic that we saw certainly in late ‘08 and ‘09,” Munoz said at a Sept. 8 conference hosted by UBS AG.

To contact the reporter on this story: Anna-Louise Jackson in New York at ajackson36

To contact the editor responsible for this story: Anthony Feld in New York at afeld2

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