Economic and market themes: 2014-10-24 Technology earnings, Chinese housing and European hopelessness

I have three areas I want to explore today: earnings reports, China and Europe. The earnings reports are mixed but generally good enough to support continued job growth and economic momentum through this fourth quarter. I also want to deep dive on tech companies. On China, the slowdown is all about housing. And in Europe, there is zero sign that political differences can be smoothed over without crisis.  

Technology earnings reports

I commented on the IBM and Apple reports earlier in the week. And while both businesses are mature, with IBM Global Technology Services and Global Business Services in particular having posted a combined revenue decline for 10 consecutive quarters, I like both Apple and IBM more than Amazon at these prices. Amazon reported yesterday and the growth numbers were not up to par, nor were the earnings. The stock was down 12% in after-hours trading as a result.

While some of this is about the Fire Phone, which I panned as DOA in June, the truth is that we are not in the growth phase of this earnings cycle. 5 years into a post-crisis business cycle, we are closing in on the period when revenue and earnings growth slow. And overpaying for revenue growth for a company that has no earnings makes no sense, least of all now.  

I said this about the Fire Phone in June: “I predict failure for the Amazon Fire phone. It is strategically the wrong phone for this time in the market’s evolution.” For me this was the first clear indication that the market’s trust in Amazon’s investment and asset allocation strategy was misplaced. Investors gave the firm way too much leeway. Amazon is writing down $170 million for this misstep. How much more rope can they get?

Microsoft, on the other hand, had a decent report. The Surface Pro 3 launch in June gives us a full quarter of Surface revenue on which to judge Microsoft’s efforts to broaden its appeal into the mobile space. I see the tablet market as a key market for Microsoft because a Surface Pro with a keyboard can serve businesses well and entrench Microsoft in a more mobile-centric business landscape. Surface revenue was $908 million for the quarter, and that’s up 127% from $400 million in the quarter a year ago. Lumia sales were also doing well, though I hold out much less hope for Windows Phone than I do for the tablet version of Windows.

At this price, I would rather own Microsoft than Apple, Apple more than IBM, and IBM more than Amazon.

But the next wave in business IT spending is going to be focused on flexible platforms that can integrate well with the new BYOD (bring your own device) and mobile-centric world. That means multiple form factors in multiple locations made by multiple OEMs on a panoply of operating systems. The CIO at Google explains well why this works:

I remember years ago, when I joined Google, I looked at the personal technology that Google gave to its people. Google allowed people to use whatever they thought was relevant to them, when everyone else gave people a black laptop and a BlackBerry and said, “You are going to do it our way.”

I think that CIOs need to understand the cultural thing—they define the culture of their company by the technology they give to their employees.

So much of the culture stems from how we work. Back in the day, people came to work to learn how to use technology. Now everyone knows how to use technology. So when CIOs narrow technology choices they actually are setting a culture that is patriarchal and rigid.

The right thing to do is to help people be as productive as possible, and the way to do that is…to understand the toolset that people who come to work every day know how to use…and want to use. To the best of your ability, you need to give them that toolset. When you do that, it creates a completely different organizational culture.

When people feel like they aren’t part of the decision-making process, they feel treated like children, they feel resentful and you find examples of belligerent compliance. When people feel like they have had a say, like they have been empowered, you get collaboration and cooperation.

WSJ: Is there a price to pay for unlimited choice, measured in efficiency?

MR. FRIED: The conventional wisdom of our industry is that we can’t have efficiency and choice, we can’t have security and choice. I have discovered during my time at Google that is a complete falsehood.

Now, you do have to think differently about the way you address IT problems. Many CIOs think that supporting personal technology is about sending that support as far away in the world as they can and delivering the worst thing you can without raising any significant objections. People end up getting someone on the phone who knows less about their problem than they do. They have to wait for someone who actually knows how to solve their problem.

If that is your approach to technology support, you had better offer as few choices as possible, because you are going to have the least qualified people you can accept.

Now, what we do here at Google is really different.

We can’t afford to have technology support where there are cookbooks and rules and every possible change is documented in advance. The people we hire to do support are more like systems administrators in another company. The first responder closes the ticket over 90% of the time in my organization.

All kinds of things happen as a result. People are happier. Your organization can change technologies more easily, and your change management becomes so much easier. You can be the instrument of change, and change management is one of the most important things companies do.

In the end, we discovered that it is far less expensive to have people who are experts than it is to dumb it down.

Also, you can go to all kinds of unconventional sources to find people who can do this. We have an IT residency program…for people who might have had nontypical majors but want to learn deeply. People who are excited about change are the kinds of people who can give great customer support.

And those people create a more secure environment.

I like Fried’s view that this the BYOD model means a more secure environment. But, of course, this is a world in which the cloud takes on importance. And that favours Google. It does not favour IBM, Microsoft, or HP and other companies wedded to the model where IT departments bought lots of expensive hardware and needed a bunch of IT consultants to run and maintain it. 

Overall, the tech space has been unusually soft this earnings season. Intel, EBay and Yahoo beat. But Google and Netflix missed. Cisco beat but is cutting headcount. Intel’s numbers say that IT spending is doing fine but I am concerned tech is a sector that will underperform going forward.

Other earnings reports

Outside of tech, the numbers have generally been middling. I am looking at economic proxies to judge how the overall economy is doing. 

McDonald’s missed and has been struggling with weakness in the US for more than a year. And I don’t think this is just McDonald’s competing against the Chipotle’s and Five Guys of the world, but rather consumption habits shifting away from take out and restaurant dining at the margin. That said Chipotle reported $4.15 a share this quarter, well ahead of estimates for $3.84. So a lot of this is McDonald’s specific.

In retail, Sears posted a lost for the 9th straight qy=uarter and Target cut full-year forecasts as did Lowe’s. Macy’s cut same-store forecasts in August. Overall, it seems like retail is in a challenging environment.

But Costco is another economic proxy I like and there profit rose 13% on stronger sales and fee revenue.

Fedex posted earnings in September and showed $2.10 vs. $1.96 expected. And FedEx is hiking rates in January.

Airlines have done really well across the board as oil prices have come down but plane tickets have not. American Airlines earned a record $942 million, United Continental earned $924 million and Southwest Airlines Co. earned $329 million. All three numbers beat forecasts. It suggests they have some pricing power and that consumers are willing to spend on flights without having the lower costs pass through.

The numbers point to a certain cost consciousness among consumers. But Chipotle vs. McDonald’s tells you that it’s not just about price as the Target vs. Sears/JCPenney wars did last decade. The numbers are not indicative of an economy about to roll over or at stall speed. The US corporate sector is doing well and the jobless claims numbers reflect this, with average initial jobless claims now at a 14-year low under 290,000. I expect Q4 to be good for the US economy.


Outside of the US, the situation is a bit more murky. In China, the latest data show 69 of 70 cities saw house prices fall, versus 68 of 70 the month prior. The average price for new homes declined 1.1% in September from a year earlier. We saw a 0.5% gain in August. So that means the first year-on-year drop in house prices since 2012 because property developers are cutting price to lure buyers due to a glut of inventory fuelled in part by expectations of further cuts. The housing market in China has entered a negative spiral where inventory builds simply because there is no demand. And the house price deflation is self-feeding as it causes buyers to delay purchases, feeding higher inventories and further price cuts. Developers are seeing cash flow problems as house sales are down 10.8% year on year through the first three quarters to $661.77 billion. We saw this in places like the US and Ireland in the housing crash. It seems to be what is happening in China.

But it is still early days. The central bank is now easing mortgage restrictions it imposed earlier. But my sense is that the deflation and inventory glut will have to cycle through. Even so, home sales in the four first-tier cities surged last weak, led by a 57.5% week-on-week rise in Shenzhen. Home sales in Beijing and Shanghai also surged 134 per cent and 78 per cent, respectively, week-on-week. Let’s see how long the price declines last. I expect further weakness.

This is the real source of economic weakness in China right now, with grow now down to 7.3% in the last quarter versus a 7.5% target. The flash HSBC/Markit manufacturing purchasing managers’ index is now at 50.4 from a final reading of 50.2 in September. But factory output dropped to a five-month low of 50.7. All of these numbers are just above the 50-point level that separates growth from contraction.


Yesterday, Ottmar Issing, the former German Chief Economist of the ECB, wrote a version of the Euro crisis that seemed almost a parody of what I wrote to you a week ago. Back on the 15th, I wrote you that: “It is this adherence to a low debt paradigm that I see as paramount in German thinking rather than the anti-inflation bias that is ascribed to the Germans. For example, as much as the Eurozone wants stimulus from Germany, the fact is Germany is concerned about its own public finances. The country is well over the 60% Maastricht debt hurdle and it has to contend with an aging society that will draw more on public finances while still trying to keep benefits high. One example here is that the SPD forced the CDU into backtracking on its desire to raise the retirement age as part of its grand coalition demands. In this context, Wolfgang Schäuble’s seeming public debt and deficit fetishism makes a bit more sense. It is driven by a sense of unease and insecurity about public finances in a country where discipline and order are praiseworthy.

“So what I see people like Weber saying is that so-called Keynesian approaches to the sovereign debt crisis are only temporary solutions and should be used in sparing measure, only to prevent crisis. His view is that the road to riches over the longer term is paved with structural reform and fiscal discipline. “

Here’s what Issing wrote in the FT yesterday:

Imagine you are asked to give advice to a country on its economic policy. The country enjoys near-full employment; its growth is above, or at least at full potential. There is no under-usage of resources – what economists call an output gap – and the government’s budget is balanced, but the debt level is far above target. To top it all monetary policy is extremely loose.

This is exactly the situation in Germany. Recently forecasts for growth have been revised downwards, but so far the overall assessment is unchanged. At present there is no indication of the country heading towards recession. Inflation is low but there is no risk of deflation. From a purely national point of view Germany needs a much less expansionary monetary policy than it is getting from the European Central Bank. This is a strong argument why fiscal policy should not be expansionary, too.

Where is the economic textbook that argues that such a country should run a deficit to stimulate the economy? There is hardly a convincing argument for such advice.


This is not to say Germany does not deserve fierce criticism. A number of policy decisions taken by Angela Merkel’s grand coalition are misguided, to say the least. Take pensions. Germany’s population is shrinking, and ageing, faster than most. The coalition’s response is a series of decisions on the public pensions system that run in the wrong direction.

They will not only have negative financial consequences, but will also deprive the labour market of skilled workers who are badly needed in sectors exposed to global competition. This is not only economically wrong. It is also unjust towards the younger generation, which will face a higher burden for social contributions combined with substantially lower pensions. 

It is exactly as I have been saying. The Germans think of the German state as too indebted and are concerned about the social safety net of their public pension system. They do not feel comfortable taking on more debt to solve cyclical problems, especially if this is debt to ease the burden on other countries. Frankly, I think the situation in Europe is hopeless from a political perspective. There is no possibility that any consensus will develop on European fiscal policy which will both meet the goals of Germany and the goals of the periphery.

On the monetary policy front, the situation is equally bleak. As I mentioned on the 15th, “Through the end of 2013, Angela Merkel had sided with SPD man Jörg Asmussen, who was her liaison to the ECB, in an intellectual spat with the likes of Stark and Weber. They resigned but Asmussen’s presence blunted the impact of those resignations. Asmussen is now gone and so the pressure for Mario Draghi to listen to Weidmann’s concerns are increased as there are no countervailing German voices on monetary policy.”

And just yesterday, Reuters confirmed not only that Asmussen’s absence is a severe blow to acceptance of ECB policy in Germany but also added credible tidbits showing that Draghi and Weidmann’s relationship is extremely rocky. Here’s the part on Asmussen:

One problem, officials says, is that since the departures of board member Joerg Asmussen and Draghi’s top adviser Christian Thimann last year, the ECB president has not had a German ally in Frankfurt who can spread his message in Berlin.

Asmussen was replaced by Sabine Lautenschlaeger, an expert in financial regulation with no political experience, and Thimann’s post was taken by Frank Smets, a Belgian.

This is why it fell to Coeure, who took over responsibility for government relations when Asmussen left, to make the trip to the Chancellery earlier this month.

And here’s the bad blood between Draghi and Weidmann:

“The relationship is totally rotten, it’s beyond repair,” said a second official who knows them both.

“It has become personal,” a third official from the ECB said. “Whenever Draghi and Weidmann are somewhere at the same event, there are bets about whether their paths are going to cross. Weidmann avoids Draghi like the plague.”

Here’s the problem. Merkel was willing to back Draghi’s measures by giving them tacit approval and not making any public statements against them when Asmussen was at the ECB and when Draghi was not making ‘political’ speeches. But the Jackson Hole speech killed this detente because the speech stepped into the fiscal debate in Germany, a big taboo. Again, the German coalition is under pressure to tighten its belt to get the 80% German debt to GDP down toward 60%. And the support for doing so is on both the left and the right. With Draghi calling for stimulus, it makes it impossible for Merkel to back him on monetary easing.

I think we are at an impasse politically. The Greek sovereign yield flare up is the first sign of round two of this crisis. And while I believe Europe can get things under control for now, the policy path is economically destructive. It’s only a matter of time before this second round of crisis becomes more acute.

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