February 10, 2003
All Eyes on Blix
The Intel Trend
Since Intel reported earnings the markets have been in a slump. In fact, the Nasdaq and Dow both hit their 2003 intraday highs (1,467 and 8,896 respectively) on January 13, a day before Intel dropped the bomb: ‘Capital spending for 2003 is expected to be between $3.5 billion and $3.9 billion, as compared to $4.7 billion in 2002’ (Analyst were calling for capex to be around $4 billion). Since Intel other tech related companies – including Microsoft, Corning, and Taiwan Semiconductor – have also announced soft 2003 capex outlooks.
While the outlook for tech spending has clearly weakened since the start of the year (most tech orientated companies also expect earnings to sequentially decline in 1Q03), the overall outlook for companies was not that bad until Dow Chemical announced it would be closing two plants and cutting its capex plans for 2003 in late January. Following Dow other notable ‘old economy’ companies, including Being, Caterpillar, and Newell Rubbermaid, offered bleak outlooks. As for utilities, the news has been equally ugly, with El Paso and American Electric Power (to name only two), announcing soft capex plans, asset sales, and lay offs.
In sum, the Intel trend (of weaker than expected capex forecasts) is ominous because companies are not likely to increase their spending plans unless the economy significantly outperforms corporate expectations. In fact, and using tech as an example, SEMI (semi.org) was forecasting a 15% jump semiconductor capital equipment spending this year (from $19 billion to $21.8 billion), but as Applied Materials, TSMC, and others have cut outlooks investor’s are left to wonder whether spending will increase at all.
Companies Cut Their Way To Profits
Reduced capex outlooks do more than simply confirm that the U.S. economy is not rebounded strongly. Rather, consistent capex curtailments highlight a broader macro theme: that corporate dollars, just like consumer dollars, go further today than they did just a few short years ago. Furthermore, this trend is showing no signs of letting up. For example, Taiwan Semiconductor expects selling prices to decline by 7% in the current quarter, Intel anticipates that margins will slump from 52% in 4Q02 to 50% in 1Q03, and Sun Micro recently announced that it is slashing certain server prices by 35%. Do any American companies purchase products from TSMC, INTC, or SUNW? If so, they continue to get more bang for their buck (which means fewer dollars are required to simply maintain capital spending). Similarly, fast food companies are enduring a pricing war, incentives for automobiles abound, airlines are touting cheap seats, and a plethora of companies have either gone bankrupt or are selling off assets/laying off workers to avoid bankruptcy. Do any American companies comp meals, buy or lease automobiles, fly on planes? Are companies looking to acquire pipeline capacity on the cheap from companies on the brink or expand through costly construction? Why go to Office Depot to buy office furniture when for every layoff announcement there is an extra desk and chair to get rid of?
Suffice it to say, Corporate America has, and continues, to cut its way to profitability. To be sure, after an overall strong year productivity dropped by 0.2% in 4Q02, capacity utilization is running at a mere 75.4% (6.1 percentage points below its 1972-2001 average) and year-over-year revenue growth is roughly half as strong as earnings growth. What all of these numbers add up to is a leaner and meaner Corporate America; a Corporate America that coasted into profits in 4Q02 even as end demand sequentially declined.
What is worth remembering is that cost cuts help boost corporate profits but hurt the broader economy.
Is Iraq Really To Blame?
There can be little doubt that Iraq tensions are to blame for recent volatility in the financial markets. For example, gold came close to hitting $390 an ounce last week, oil is hovering well above $30 a barrel, and all the major U.S. equity markets lost ground last Friday even though the jobs report was a positive surprise (incidentally, jobs growth in January was almost entirely seen in retail industry due to seasonal revisions and the adoption of new BLS methodologies. Moreover, the rise in ‘Not in Labor Force’ data continues to help keep the unemployment rate low. If you deduce that discouraged workers and ‘NILF’ people are really unemployed the unemployment rate would nearly be 7%). However, Iraqi tensions, while clearly igniting war premiums in gold/oil and discouraging investment in stocks, may be overstated. Can Iraq tensions be blamed for excess industrial capacity? Did Iraq infiltrate AOL’s balance sheet and decimate nearly $100 billion of paper wealth? Did Iraq inform insurer AIG that it will cost them $3.5 billion to settle old claims on their books?
In short, Iraq is a scapegoat for the weakening U.S. economy.
Opinions Abound
My opinion is that U.S. has not made the case for an immediate strike against Iraq. Rather, the U.S. seems to making the case that since an attack is inevitable they would like to strike before it gets too hot. After all, if Iraq has been allowed to deceive everyone for more than a decade is there any immediate danger in allowing inspections to continue for a few more months? Is Saddam really in a position to do anything but retreat?
That said, I don’t buy the notion that the U.S. must adhere to another UN vote and/or not dare risk ‘going it alone’. Rather, since Iraq does not have any strong allies the U.S. could attack tomorrow and, if success was quickly achieved, current ‘do not attack Iraq’ pleas would soon be forgotten.
In hindsight, the major flaw in American policy was to seek UN approval. By taking this path – ‘your days are numbered Iraq, but we will wait a few more days for the UN to come around’ – the U.S. has corned itself. To be sure, as Bush tries to convince the world that Iraq is in material breach what he is also trying to do is convince the world that Iraq should be attacked without a so called ‘smoking gun’? Why use the UN at all if you do not have a smoking gun and/or you are going to attack without UN approval?
Sadly, because war does look inevitable, Iraq will likely become page 2 news in the near future.
Conclusions
The ironic twist to the Iraq story is that if the situation does become page 2 news, hopefully without the need for war, it will be because the U.S. has played hard ball. By lining up troops on the Iraqi border and threatening to go it alone, the U.S. has forced Saddam to either come clean or face an attack. It is worth remembering that U.S. aggression is the only reason why UN inspectors are back in Iraq today.
The ironic twist to downgraded capex forecasts and costs cuts in general is that while these cuts are largely regarded as an economic negative – ‘companies must start spending so the economy doesn’t slip into recession!’ – they are actually company positives. As consumer penchant for debt continues to decline (consumer credit dropped again in Dec) and cash refinancing have less of an impact going forward, all that is keeping any hope of a continued profit recovery alive are continued corporate cuts.
The most ironic twist of all is that the demise of the US dollar is actually good news for the United States. A weaker dollar helps the U.S. combat deflation and gives American companies increases exporting power. Moreover, a weaker dollar also helps American companies compete at home, as imports become a little more expensive. Granted, there remains the risk/realization that the US dollar will fall too rapidly or that since everyone is dependent upon the U.S. market no other growth engine will emerge to absorb American exports. Nevertheless, and despite strong dollar mantras from Snow aimed at keeping the dollars slide organized, a weaker dollar is in the best interests of the United States.
Due out this week is Industrial Production (Jan), Retail Sales (Jan), Mich. Consumer sentiment (Feb), and Greenspan’s semi-annual assessment of economic prospects before the Senate Banking Committee (Tuesday). While these economic reports/events are notable, the main event for the markets is Blix’s update to the UN on Friday.
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