Amid Dry Holes, Positive Change at the Margin

by Shawn Narancich, CFA Senior Vice President of Research

Revisionist History

Amid hundreds of quarterly earnings reports daily, investors were challenged to stay on top of a slew of important economic data hitting the tape this week. While always old data by the time the report sees daylight, GDP for the U.S. economy remains an important benchmark for investors and the Fed, and the 1.7 percent growth rate came in substantially above where we thought it would for Q2. Underlying detail reveals that consumer spending continues to support growth, with housing construction and a reduced drag from government spending also helping boost numbers. That U.S. businesses had sufficient confidence to build inventories in the quarter (thus also adding to reported GDP growth) is a good sign. Comprehensive revisions from the Commerce Department, dating back to 1929, showed that GDP growth was better than expected last year at 2.8 percent, with the Great Recession also being less severe than previously advertised.

Bullish confirmation came from another number that isn’t subject to ex post facto revisions – the survey of U.S. purchasing managers. That number skyrocketed to 55.4 in July, meaningfully above the growth/contraction dividing line of 50, and the strongest reading for U.S. manufacturing in nearly two years. Coupled with better than expected manufacturing indicators in China, the news helped to confirm stocks’ recent gains and was a catalyst to push both the Dow Industrials and benchmark S&P 500 Index above the 1700 level. With blue chip U.S. stocks up about 20 percent for the year, the question now is whether the economy can attain the higher rate of growth investors increasingly expect in the back half of 2013.

Help Wanted?

Friday’s monthly payroll report completed the week’s troika of important economic indicators, and the fact that a net jobs gain of 162,000 disappointed expectations met with a yawn by investors. After all, what’s sustaining the Fed’s quantitative easing program and well contained labor costs is a jobs market that remains slow to expand, keeping pressure off employers to raise wages and pushing corporate profit margins to record levels. Second quarter earnings reports have confirmed the bottom line benefits which, when combined with share buybacks and acquisitions, promise to deliver 6-8 percent profit gains for the full year.

Dry Holes

This week, it was Big Oil’s turn at the earnings confessional, and unfortunately for them, the congregation of investors was in no mood for penance. One after the next – first British Petroleum, then Royal Dutch Shell and Exxon Mobil, and finally Chevron – delivered what we judge to be Big Oil’s worst collective set of numbers in recent memory. In Royal Dutch’s case, this Netherlands-based integrated oil company continues to be confounded by pipeline sabotage in Nigeria, a production mix weighted toward natural gas, and failure to gain traction in the booming U.S. shale plays. The stock rightfully got hammered, off almost 6 percent on the discouraging report. Aside from company-specific issues with Royal Dutch, the common denominator for the four Super-Majors was poor refining results. Contraction in refining margins was most pronounced domestically, where the rising cost of benchmark West Texas Intermediate (WTI) crude pinched margins relative to the price of gasoline, diesel, and jet fuel production. As takeaway capacity has increased from key producing basins in North Dakota, West Texas, and Canada, the anomalous discount of WTI to Brent has disappeared, and with it, the outsized profits that mid-continent refiners once enjoyed. Remarkably, all four companies missed consensus earnings forecasts and all four experienced downdrafts in their stock prices afterward.

Our Takeaways from the Week

  • An important week of economic news flow was encouraging overall, and stocks responded by trading to new highs
  • Big Oil was an exception to what has generally been a decent second quarter earnings season