THE ECONOMY

Massive stimulus measures around the world are working and the “Great Recession” has ended.  Today, the world’s economies are experiencing a synchronized recovery with projected growth over +3% in 2010 led by a strong rebound in emerging economies and improving demand.  Governments worldwide are committed to stimulating economic activity until a self sustained recovery is firmly in place.  During the second half of 2009, the U.S. economy will grow for two consecutive quarters for the first time since 2007 and the leading indicators are forecasting a definitive upturn in activity.  The index has grown at an +11% annual rate since March – the fastest six month rate since the 1981-1982 recession.  In 2010, the American economy is expected to grow +3% supported by a rebound in residential housing construction, investment in capital equipment, inventory rebuilding and government stimulus from the American Recovery and Reinvestment Act of 2009.  Personal consumption has improved during the course of this year and will continue to strengthen with greater consumer confidence and improving employment trends sometime next year.  But consumer spending increases are expected to be modest because of the deleveraging trend.  The U.S. export sector is contributing to GDP growth due to a weak dollar and improving global trade patterns.  We are encouraged by the pace of the recovery, but recognize that work remains to replace the eight million jobs lost during this recession.  For perspective, unemployment has risen for 21 consecutive months representing the worst increase since the WW II demobilization and the longest period since these numbers were first published in 1939.  Today, private employment is 2.6% below its 2000 peak.  However, it is important to recognize that the Federal Reserve is coordinating with its international counterparts to secure a sustained economic recovery and to strengthen our legal, regulatory and supervisory framework to help prevent a recurrence of the severe financial crisis of the past two years.

CORPORATE PROFITS

The U.S. economy recently experienced its worst profits recession since the Depression.  Since peaking in the second quarter of 2007, S&P 500 operating earnings fell more than 55% - the greatest percentage decline since the 1930’s.  This downturn in profits has been broad-based across almost all industries due to an abrupt decline in final demand for goods and services, but losses at banks, financial companies and auto manufacturers weighed heavily on the aggregate figures.  In fact, if the large write-offs from banks and losses associated with companies who have been deleted from the S&P 500 (e.g. GM and AIG) are excluded, then earnings declined approximately 20% from their peak.  This decline is not as dramatic as the headline numbers indicate, but is still significant.  This analysis is important in considering the timeline for corporate profits to exceed their prior peak, which suggests that the trough is not as deep as commonly believed and the recovery to prior peak levels may be more rapid than anticipated.  S&P operating earnings are projected to be around $61 per share this year followed by an increase of +25% to $76 in 2010. Over the intermediate term, earnings may exceed their 2007 peak in 2011-2012 – a powerful trend.

There are three key factors influencing the trajectory of the earnings recovery -- sales growth, productivity and corporate balance sheets.  Sales have declined for most companies due to the rapid decline in economic activity in late 2008.  During the first half of 2009, the median decline in sales for S&P 500 companies was -10% with over 375 companies or 75% reporting a decline.  In 2007, the median increase in sales was +8.5% with 425 companies reporting an increase.  Currently, sales growth rates are bottoming and are expected to increase as final demand strengthens with improving consumer confidence, financial incentives associated with government stimulus and the improved availability of credit.  Furthermore, inventories are at low levels and a period of rapid restocking will likely occur as the economy gathers more strength.  Manufacturers and distributors have taken “just-in-time” to an extremely tight level, which slowed ordering patterns in the downturn and will likely boost orders during the upturn.  Importantly, productivity is improving after a period of restructuring and downsizing.  During the latter phase of the last economic expansion, productivity growth slowed to less than +2% per year, but productivity recently improved by +6.6% in the second quarter of 2009.  Corporate operating margins are primed to expand and, as a result, earnings growth will increase faster than revenue growth in 2010. 

Overall, Corporate America is in strong financial health - except for financials – and well prepared for a variety of recovery scenarios.  Corporations have been building liquidity by reducing their investment in capital expenditures and working capital while reducing their stock repurchases and dividend payouts.  For perspective, the S&P 500 dividend is likely to decline -25% in 2009 with the greatest number of individual company dividend cuts in 50 years.  As a result, cash on the balance sheets of the S&P Industrials is $775 billion – the highest level in history.  These austerity tactics ensure safety and survival, but also curtail near term expansion.  From this point, we believe the pendulum will begin to swing back to an expansionary mode and the large cash hoard will be gradually spent on capital expenditures, corporate acquisitions and stock buybacks.  A recent Conference Board survey determined that 51% of chief executives expect conditions in their industries to improve over the next six months compared with 12% in the fourth quarter of 2008.  The fact that balance sheets are strong is a positive that will help companies take advantage of their future growth opportunities.