A tepid cyclical lift

Tom West, Director of Equity Research | April 28, 2014

  • Cyclical investment and discretionary spending are on track to deliver earnings growth of 7% in the S&P 500.
  • Strength in some consumer durables appears more of a “wallet share” gain than a general lift due to recovering wages or a release of excess savings.
  • Construction and energy are poised for another year of growth, while “enterprise” spending and investment in the tech sector remain challenged.

The S&P 500 Index should grow earnings by about 7% this year, while consensus estimates for the U.S. economy are for 2.5% real growth. One reason for the gap between the two numbers is that the constituent companies of the broad market have a more cyclical tilt than the economy itself, and could be expected to expand faster in a recovery. Fair enough. But are the cyclical drivers like investment and discretionary spending on track to deliver that cyclical boost to earnings? The answer is probably yes, but only if expectations are tempered.

Strength in some consumer durable channels is encouraging, but appears to be more of a “wallet share” gain than a general lift due to recovering wages or a release of excess savings. (Remember home equity lines of credit?) Autos, home-related durables and maintenance spending are doing well but seemingly at the expense of other consumer expenditures like apparel and dining and some parts of consumer staples. Auto sales were strong last month, a 16.4 million annual selling rate, tracking above last year’s 15.5 million sales. And appliance sales are expected to be up 5%-7% this year.

Although weather conditions in the first quarter put a damper on construction activity, there were still some positive data points, and both commercial and residential construction should do well this year. Non-residential construction is looking good for 2014, with growth expectations in the 5% range, driven by strength in leading indicators like the Architectural Billings Index (ABI). Caterpillar saw 15% growth in trailing three month orders for construction machinery as of March, and Otis saw a mid-teens growth rate in North American elevator orders. Residential construction growth is expected to moderate from a 19% pace in 2013 to just above 10%. Home price inflation and decreasing affordability are threats, however. Residential remodel activity is expected to accelerate, with the Harvard Leading Indicator of Remodeling Activity projecting mid-teens growth following mid/high single digits in 2013.

In the tech sector, “enterprise” spending and investment remain challenged. Larger technology vendors are seeing an improving European environment but are still experiencing difficult comparisons in emerging markets and U.S. government. Technology hardware companies are facing headwinds to growth, as enterprises are more hesitant to invest in additional data center and other capacity ahead of the adoption of “private cloud” and “public cloud” information technology architectures.

The North American energy complex is poised for another year of growth, albeit at a lower rate than last year. Trade groups are looking for capital expenditures in the energy sector to be up 2.5%-3%, following 7% during 2013, 16% in 2012 and 25% in 2011. Columbia Management energy analysts estimate that spending will increase a bit more than the 2.5%-3%, especially if commodity, U.S. gas and oil prices stay firm. But a return to the higher growth rates of prior years is not expected.

So despite historically low cost of debt and equity financing, cyclical spending remains more granular than widespread. Instead of a broad need to spend on increased capacity, we see that need only in a few sectors. And we do see some investment to solve obsolescence, such as the need for more fuel efficient airliners. All that said, the patchy and begrudging level of cyclical spending ought to be able to support its part in earnings growth of 7%, which is a few points below “bottoms-up” consensus of Wall Street analysts.