General Electric: A Winner in the Mid-Cycle Slowdown

General Electric (GE) has its toes in so many ponds that it would take several articles to go through all of its divisions and sub-divisions. Instead, a macro approach is more appropriate when attempting to analyze the outlook for this Goliath.

There is no doubt that we are currently in the throws of a mid-cycle slowdown. Verification as follows:

Federal Reserve Monetary Policy

Due to past lapses in M3 growth constraints, we currently are abashed in liquidity. On the one hand this contributed to inflation pressures. On the other hand the excess liquidity not only provides the necessary cushion for a soft landing but also allows the Fed to adopt its current neutral or perhaps slightly restrictive monetary policy. The latter is to reduce inflation.

To put some numbers to this, look at CPI and GDP in relation to the Fed rate.

In June 2006 the 12 month CPI rate was 4.6%. In January 2007 the 12 month CPI rate was 2.1%. Putting aside the up tick in February, when measured against a consistent Fed rate we get a 2.5% rise in interest without actually increasing the overnight rate. Now my friend Phil Davis (Seeking Alpha options guru) is going to scream - what's with oil and energy costs!!! Well Phil, the numbers above include food and energy. If anything, you could say that the core rate has been more stable over the same period. However, the core rate is continuing to drift south thus obtaining a tightening effect when measured against the constant Fed rate.

I find the GDP figures to be more interesting. For the sake of sanity, we are using current Dollar GDP or real GDP + inflation, as you may prefer to call it. Over the last 9 months the GDP rate measured 4.5% verses a 5.25% Fed rate yielding a negative 0.75%. Twelve months prior to this, while the Fed was constantly increasing rates, GDP averaged 6.9% and the average Fed rate for the period was 3.5%. That's a whopping 3.4% stimulant.

Summary: We have gone from a 3.4% economic stimulant to a 0.75% restrain.

Housing Recession

In case you haven't noticed, the economy is not in a recession, housing is. The primary causes for this is affordability. Housing demand is still relatively strong (excluding overbuilt locations) as new available land is restricted. Taking this a step further; affordability eroded as prices increased in comparison with wages. Had the erosion occurred due to restrictive monetary policy, lowering the interest rate would accelerate a rebound. Since this is not the case, the housing recession should last at least another 12 to 18 months. The effect of the housing recession will not spill over to other segments of the economy (excluding subprime etc.) as there has not been an 'affordability' issue, meaning that there is ample liquidity that has not been subdued by high interest rates.

In past housing cycles, mortgage rates declined drastically. This time this is unlikely for two reasons. First, the rates are not that high to begin with. Second, any softening in rates will be used to compensate for previous mistakes. In other words, new borrowers will be paying a small premium to cover increasing delinquencies on former loans to others. This in turn may increase the extent of the housing recession yet at the same time will mitigate, to a degree, the fallout effect of the subprime issue.

Summary: Housing recession will not cause a full blown recession (unless interest rates increase 1.25% coupled with unemployment over 6.2% - not within the scope of this article).

Economic Risk & Credit Risk

Basic economic risk has declined over the past decade due to the moderation of inflation. As pointed out recently in numerous articles, the lower economic risk factor has translated to a lower long term VIX.

Credit risk has been at one end of the pendulum for the past several years and is in the process of swinging to the other end. While economic stimulus was being provided by a favorable Fed rate, corporate balance sheets improved in tandem with years of continuous earnings growth. This eliminated the need to factor in premiums for risk. In essence just about anyone could borrow any amount. Now that the Fed stimulus has been removed risk spreads need to increase back to more acceptable / historical levels. Lower corporate earnings growth results in lower liquidity growth.

Summary: Basic economic risk is historically low. However, credit risk is on the rise, slowing economic growth.

Now that we have established that we are in a mid-cycle slowdown and not a full blown recession, it stands to reason that some companies should perform better in times of slower growth in comparison with others. Naturally as appetite for risk in general decreases, companies without earnings that were flying high on YOY revenue figures are going to feel some pain. The dot.com era of revenues without profits has come and gone again.

The Case for GE

Historically (from memory, I didn't look this one up) and logically, when profit growth is no longer the driving engine behind the market, quality takes over. Like other mega caps, GE is obtaining extra growth via acquisitions during the slowdown.

Once the pattern becomes apparent, higher multiples are awarded to mega caps that are able to sustain current or higher earnings growth. Smaller companies tend to show below par earnings growth and try to compensate with top line growth. More often than not, emphasizing revenue over profit leads to margin reduction. In turn this leads to even lower earnings growth, at times lower YOY earnings, resulting in a multiple reduction.

Earnings are king and queen during a slowdown and size does matter.

Disclosure: No conflicts.