CIBC says "Fed Easing Cycle No Panacea"
This perspective on yesterday’s “Bring back da Bull” rate cut is from CIBC’s NYC-based Industrial Diversified research team. It’s a poignant reminder that although the U.S. Federal Reserve might have been willed by market players (such as Larry Kudlow) to make their “shocking” move, it isn’t all a bowl of cherries in the U.S. economy right now:
We remain comfortable with our Underweight thesis on our Industrial Diversified universe of coverage. The aggressive Fed rate cut yesterday of 50 bp does not change our stance at the present. The Fed cuts rates for a reason and is tied to what we believe are heightened risks of recession. Many data series including the leading indicators, ISM, truck tonnage index, amongst many others remain weak or have weakened further, and coupled with the recent credit turmoil have heightened risks to the downside for growth particularly in the U.S. Some may look at the Fed rate cut and the start of what is likely an easing cycle as a panacea for our group and the start of a new upturn. However, based on our analysis, the start of an easing cycle is not kind to our group, which is more influenced by weaker economic activity. In fact, our group will typically underperform the broader market (as measured by the S&P 500) by as much as 200 bp from the start of a Fed easing cycle until our group finds a bottom to work off of. This takes an average of about four to five months, but can take over a year during a recessionary period (such as in the 1990/1991 recession).
AME, DHR and ITW (all of which we currently rate SO) have all fared better historically than ETN and PH (which we currently rate SU), outperforming ETN and PH by an average of 500 bp during an easing cycle. On an individual stock basis, ITW led performance, while PH lagged significantly. Given what we believe are even less cyclical portfolios with better geographical balance currently, we expect our SO rated names to lead performance during this easing cycle. Fortunately, the good news is that this easing cycle should bring us one step closer to finding a bottom that should create attractive buying opportunities across our Industrial Diversified group, yet, in our view, it is still too early to signal the “all clear” sign just yet.
Fed Eases for a Reason
After growing recognition in recent weeks that the U.S. Federal Reserve would cut interest rates, the U.S. Fed went ahead and cut interest rates yesterday by even more than most anticipated, taking the Fed funds rate down 50 bp to 4.75% from the previous 5.25% level. The 5.25% level had been in place since the last Fed rate increase in June 2006, which followed 17 rate increases since June 2004 from the exceptionally low 1.00% level. Yesterday’s Fed action starts what could be the beginning of an easing cycle for the Fed, we believe made
possible by other central banks, notably the ECB that recently kept rates constant and pulled back from what was previously aggressive tightening rhetoric due to inflation fears.
However, the Fed tightens for a reason. Downside growth risks in the U.S. have increased and much of our data had been weakening or outright declining for the better part of a year or more. The Conference Board’s index of leading economic indicators has been negative y/y for seven of the past nine months, which usually precedes a recession. The US ISM index of manufacturing activity has weakened recently after what looks to have been temporary strength in 2Q, and has been in a downtrend since May 2004. Truck tonnage index levels, which measures freight activity in the U.S., have been negative y/y for 16 out of 19 months. Meanwhile, the housing downturn continues and will likely see further weakness through 2008. Much of this had already been known, yet the recent credit turmoil has likely added an additional layer of risk, a layer that appears to have caused the Fed to take action. We believe this has clearly heightened recession risks in the U.S. Importantly, most of our Industrial Diversified coverage universe has about 2/3 sales exposure to the U.S. markets, with much of the remainder based in Europe.
Despite moving lower already, growth forecasts remain optimistic, in our view. Interestingly, consensus Blue Chip forecasts still look for acceleration in consumer spending in the U.S. from 1.4% in 2Q to 2.2-2.3% in 3Q/4Q, which appears a key risk given the ongoing weakness in housing, tightening credit and higher energy prices. Moreover, even in Europe, growth in Germany for 2Q disappointed and Blue Chip Consensus forecasts for the Eurozone actually moved lower this past month for the first time since April 2006. Eurozone growth is expected to
average 2.6% for ’07 and 2.3% in ’08. This backdrop has been central to our Underweight thesis on our group, where we remain comfortable, particularly given the economic sensitivity of most in our group. Fundamentals have been deteriorating for quite some time as noted earlier, yet we also believe private equity/LBO activity likely extended performance, and has since waned. Recent optimism has been tied more toward international markets, yet given their
limited exposure, many would require acceleration in these markets, in our view, to help offset the declines in the U.S. markets, which appears unlikely, especially in Europe, where most companies’ international exposure is derived from. We’ve also heard from many that despite the Fed’s tightening campaign in recent years, interest rates are already low by historical standards and should be supportive to our group. However, we should note that any analysis should
incorporate two things: 1) Inflation adjusting the interest rates given the inflationary late 70s / early 80s skew any absolute analysis, and 2) Consider the delta in interest rate policy. Adjusting for inflation, in looking at the graph below, interest rates actually turned restrictive over the past 11 months, but probably more importantly, the delta in the interest rate tightening policy we’ve seen in recent years has been the largest seen since the early ‘80s. This delta, particularly as it has caused interest rate policy to turn restrictive, in our view,
has been a key behind the recent broader slowdown. Coupled with the easy lending practices through the housing boom, this has likely caused even higher growth risk, thus the start of what appears to be an easing cycle for the Fed.
Start of Easing Cycle Is Typically Unkind to Industrials
Given the economic sensitivity of our group, many look at Fed easing actions as being a positive for share price performance. However, as noted earlier, the Fed typically eases for a reason, and that reason is typically tied toward growth risks or an outright deterioration in the economy, particularly an easing cycle in its early stages. In fact, based on our analysis, from the start of a Fed easing cycle, share price performance in our Industrial Diversified group typically falls on an average absolute basis by over 7% until it finds a trough, underperforming the broader market (as measured by S&P 500) by almost 200 bp, on average. Based on our analysis, the trough in the shares typically does not occur until about 135 days after the first Fed rate cut, or roughly four or five months later. EPS estimates typically bottom about 106-122 days after the trough in the share prices, as lower EPS is fully discounted three to four months in advance. Importantly, particularly given the heightened recession risks currently, easing cycles in advance of recessions typically last longer and the time from the first rate cut and the trough in the share prices can be significantly longer, based on our analysis; the same goes for the EPS trough.”