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Signs of Stronger U.S. Economy Despite Continued Unrest in the Middle East

Posted by Eric Anderson on April 19, 2011

eric_f.jpegStocks entered 2011 with a continuation of the rally which began in August of 2010.  However, the advance quickly changed course in mid-February on concerns that unrest was spreading rapidly in the Middle East and as a result causing the price of oil to spike.  Specifically, the S&P 500 began the year at 1,258, peaked at 1,343 on February 18th and quickly lost 7% before putting in a bottom on March 16th.   Over the last two weeks of March it climbed back to the 1326 level for a total first quarter gain of 5.9%.  Given the major calamitous events that took place during the first quarter, e.g. Middle East protests and rioting, and the Japanese earthquake / tsunami with its crippling damage to the 4 nuclear reactors at Fukushima Daiichi and the very serious release of radiation, it is remarkable that the markets were able to deliver their highest first quarter return of the past 13 years.

Smaller companies proved the strongest so far this year as reflected by the Russell 2000 Index (small caps) which rose 7.9%, while the Dow Jones Industrial Average increased 7.1%.  The NASDAQ’s 5% return was a little shy of the S&P 500’s 5.9%, but both were well ahead of the laggard for the quarter, the MSCI EAFE index (a benchmark of international stocks), which rose 3.5% and was obviously affected by the sharp sell off in the Japanese market.

Each of the ten S&P 500 sectors had positive returns, though there was a wide divergence in sector performance.  Given the significant rise that we have witnessed in the price of oil it should then come as no surprise that the best performing sector during the quarter was the Energy group, increasing 16.8%, which was almost double the 8.8% increase of the Industrial sector.  The influence of oil prices was further demonstrated as Industrials couldn’t keep pace with Energy even though it has been benefiting from higher exports made possible by weakness in the U.S. dollar.  Health care rounded out third place with its advance of 5.6%, and the Consumer Discretionary, Materials, and Telecommunications sectors all had increases in the 4.5% to 4.9% range.  The bottom four sectors, Consumer Staples, Financials, Utilities, and Technology, delivered returns that were clustered in the 2.5% to 3.5% range.  Some of the laggard sectors were simply taking a rest after strong performance during 2010, such as the Consumer Staples and Financials, whereas the Utility and Technology sectors continued the relative underperformance that they exhibited throughout 2010 as a whole.  Utilities have been under some pressure stemming from uncertainty in the administration’s plan to have the EPA institute a program which attempts to reduce the burning of carbon based fuels, primarily coal. 

Events in the Middle East and continued unrest have precipitated a rally in crude based on the potential for supply disruptions.  This increase has taken oil to 2 ½ year highs, pushing the price at the pump to the $4 per gallon level.  What started as a strongman rule in Algeria quickly spread to Egypt which had seen plenty of protests earlier as a result of skyrocketing food prices.  The discontent has now spread around the northern tip of Africa and also into the heart of the Middle East, Yemen, Syria, and Bahrain.  The ongoing civil war in Libya raised additional concerns and helped extend the rally in crude.  The entire move in oil has been on the fear of a reduction in supply given the earlier unrest in Algeria and the present halt in oil exports from Libya.  Both countries have the ability to export around 1.8 million barrels of crude per day and the oil that is not flowing from Libya has been made up by other OPEC countries.

Back in May of 2010, we discussed how examining the current production and consumption of cardboard boxes can be a good gauge and insight into current and future economic activity.  The theory is that if the economy is expanding then so too will the demand for cardboard boxes, as all things that are made are eventually shipped as parts or raw materials, or if a finished good is sold either at wholesale or retail, then it has to be delivered to a store or home, almost always in cardboard boxes.  The key input in the construction of boxes is linerboard.  The news on linerboard is very encouraging as current inventory levels of linerboard are again running at very low levels.  Previous levels of high demand and low mill inventories allowed the manufacturers to raise prices twice during 2010, by a total of $110 per ton, such that prices are now above the peak level experienced in 2008.  After many capacity closures in the North American marketplace, supply is now closely aligned with demand.   And that demand has continued to be robust, so much so, that from month to month there can be very little tonnage available for the export market, and mill operators are rumoring of another $50 per ton price hike some time this July.

The March data showed continued strength, as shipments rose 4.1% and were the highest level in any month since July 2008.  Combined inventories at box plants and linerboard mills fell 165,700 tons, which was greater than the normal 76,000 ton reduction usually experienced in the March timeframe.  The decline brought inventories to their lowest level in 2011, and total inventory levels are presently 2.31 million tons, which is only 4 weeks of supply, and are at levels not seen since 1981 when the economy was much smaller than it is today.  The U.S. linerboard industry is running at 94.1% capacity, versus 93.4% last month, and compared to only 78.8% during the recessionary period of April 2009.  The healthy demand of linerboard suggests that both manufacturing and consumption is relatively strong in the U.S. as the current low inventory levels of linerboard are very sensitive to either the strengthening or weakening of economic activity.