Thursday, July 9, 2009

Is Alcoa a bellwether for the US economy?

It is becoming pretty tough to answer yes to this question, especially after Alcoa's Q2 earnings release.

We won't go through the earnings results as everyone is aware that they came in better-than-expected, driven by cost reduction and strong demand in China. Another pleasant surprise was the Company's revenue figure, which was nearly $300MM higher than what the analysts were looking for.

With that said, from a macro standpoint, nearly everything else mentioned on the call was negative. It appears that the Company's well-being is in China's hands. We do not view the better results as a signal for an economic turnaround in the U.S. anytime soon.

According to CEO Klaus Kleinfeld, global aluminum demand projection for 2009 has not changed. It remains at -7.0%. However, without China, that figure slides down to -10.0%. The Company's projection for various end markets is provided below:

Source: Alcoa analysis

Obviously, when it comes to North America, we're not seeing any good news in the table above. And who knows how significantly this could change in 2010, given the lack of consumption, unemployment, and higher savings; all of which are indications of no demand, resulting in less manufacturing and construction.

China is the only region in which Alcoa expects to see some growth. According to Kleinfeld, the fact that China's stimulus plan has strong infrastructure components, or is "shovel ready", is helping Alcoa. In addition, given China's average domestic savings rate of 40%, the government is pushing the Chinese to lower that rate, open credit card accounts and consume. Unfortunately, that is not the case with us, nor can we afford to do that.

Kleinfeld did mention that the automotive industry in the U.S. may be stabilizing in 2H09, but then again, we do know that such stabilization is nothing but inventory replenishment, demand for which is not yet clear. And we must say this may also be partially driven by the 'cash for clunkers' government policy, which will not positively impact auto demand in the long-run. As a reminder, June auto sales (announced last week) came in below expectations, below 10.0MM and below sales in May.

Overall, even though Alcoa's Q2 results beat expectations, we do not view it as an indication of a turnaround in or stabilization of the U.S. economy. Cost reduction and strong demand from China were behind those results. We do not yet see significant increase in consumption, stabilization of the unemployment rate, decline in savings rate nor an end to the deleveraging that nearly every household continues to execute.

Monday, July 6, 2009

The fantasy-to-reality consumer transition will take time

It appears that it will take some time for consumption to rebound in the U.S., which could lengthen the recovery of this latest recession.

In order for consumption to rebound, we need some stabilization in the declining consumer revolving credit, combined with increase in consumer confidence. However, both continue to decline. We note that the increase in consumer confidence since April '09 is likely due to what we believe to be a non-warranted 33% increase in the equity market since the March lows.
What we are looking for is a combination of deleveraging, higher savings rates followed by stabilization in unemployment, all of which represent a slow recovery.

Although we are seeing some deleveraging in consumer balance sheets, as the revolving credit continues to decline (Figure 1), we have not yet seen a correction in revolving credit as a percentage of disposable income (Figure 2). We believe this is mainly due to continuing rise in unemployment (Figure 3), which we do not view as a lagging indicator in this recession. We also believe that more and more of the currently employed consumers are becoming cautious as they may be next. This also explains the continuing increase in savings rate.

Figure 1

Figure 2

Figure 3

Higher credit card default rates, decline in home equity loans (as the housing market has yet to hit a bottom) also provide support for our view that consumption recovery will not begin in Q3, nor in Q4.

We would like to see savings rate climb to 8% (from 6.9% in May), the level at which it stabilized in the late 80's. In addition, although it may sound extreme, we would also like to see revolving credit as a percentage of disposable income to decline to 4% - 6% (from 8.5%), where it was in the late 80's. During the mid-to-late 80's, we believe consumers were 'wowed' more by credit cards. Unfortunately, over time, the increased awareness of credit cards, changed American consumer behavior and started the enormous leveraging for which we are now paying. Of course, although we are hoping for consumers to once again become realists, the federal government's policies and unfounded optimism may lengthen the fantasy-to-reality transition.

Lastly, the Fed will provide an update on change in consumer credit on Wednesday at 3pm (ET). The current consensus stands at -$7.5 billion, which we hope will be met. We note that although this data is somewhat lagging, again, the trends we see will provide us a clearer picture of a maybe-recovery.