The Economy: Key Signals Beyond the Bailout

With the start of third-quarter earnings reporting coming up, investors will soon be shifting their attention from Wall Street to Main Street

Even as Treasury Secretary Henry Paulson and Federal Reserve Chairman Ben Bernanke continue to make the case on Capitol Hill for a speedy delivery of a gigantic bailout package for the troubled financial industry, questions about the near-term prospects for the broader U.S. economy abound. The ongoing drama has tended to obscure some of the other pressing issues for the economy. But with the start of third-quarter earnings reporting season just one week away, it won't be long before investors start to shift their attention from the latest Wall Street debacle to the ongoing challenges faced by Main Street.

The two realms of economic activity are linked of course, but the government's historic actions these past two weeks have all but eclipsed what had been driving the markets until recently: concerns over anemic consumer spending and rising unemployment. To the extent that strength in the U.S. economy has been led by robust exports -- a byproduct of a seven-year decline in the dollar -- a $700 billion bailout fund or whatever size the Troubled Asset Relief Program turns out to be could be just the thing to ensure the U.S. continues to stave off a technical recession, since everyone seems to agree the added national debt would further hobble the greenback.

Consider this: Of the 3.3% growth reported for U.S. gross domestic product in the second quarter, 3.1% came from exports. Although the resurgence in the strength of the dollar since early August until last week has helped tame commodity prices, which may boost consumer spending, the loss of the competitive advantage in world trade provided by a weaker U.S. currency may more than offset those gains and dramatically slow the economy's expansion.

It may be useful to zero in on a diverse group of industries and their prospects. Here, BusinessWeek takes a look at some of the bellwether groups that may offer some clues as to how the economy will perform as we head into the homestretch of 2008.

Software

One of the strongest export sectors has been technology, with non-U.S. markets generating as much as one-third of total revenues for some software manufacturers. Some observers believe that technology companies will continue to do well even if the global economic slump deepens because foreign governments and businesses can't afford not to keep upgrading their systems and processes. Others see weaker economic conditions drying up businesses' investment in information technology.

Oracle, seen as a leading indicator of the fortunes of enterprise software manufacturers, recently said it saw no weakness for the third quarter and that its product pipeline is robust, according to Richard Williams, a software analyst at independent research firm Cross Research in Livingston, N.J. But when he took a deeper look at the company's numbers, Williams says he saw some signs of decelerating business activity, most notably in database support and update lines, or the maintenance service and patches customers buy to take advantage of product improvements.

"Oracle has been surprisingly weak in database applications for two quarters in a row," he says. "That's not something off-the-cuff I'd think customers would economize on." That could be an early indicator of weakness in larger companies since Oracle sells primarily to large, high-end and midsize companies around the world, he adds.

The timing of the escalation of the financial crisis is likely to hurt tech firms, too, he warns. The last two weeks of the quarter "are the most important weeks for software companies to get deals done," he says. "It's hard to see how it won't have some impact for the rest of the companies in the group."

Smaller companies that serve niche markets, such as Aspen Technology or JDA Software, may not be as affected in the near term because they're less subject to sticker shocks than their bigger rivals and it may still be possible for them to close deals at the departmental level without having to get approval from a client's chief financial officer, says Williams.

"If the dollar stays anywhere near the highs of August and early September, I think it will have meaningful headwinds for software companies as they report [earnings]," he says. Besides Oracle, Microsoft, IBM, and Lawson Software all are very internationally oriented and would be vulnerable to a stronger dollar.

Commercial Transport

Total traffic in the railroad industry had fallen about 1.2% year-to-date as of Sept. 13, with the weak economy continuing to keep volumes down, Morgan Keegan analyst Art Hatfield wrote in a Sept. 23 research note. Union Pacific's volumes are down 5% so far in the third quarter, more than double the 1% to 2% decline the company had estimated. That didn't stop Union Pacific from raising its profit forecast for the quarter on Sept. 22 by roughly 13% to $1.28 to $1.33 a share based on lower diesel fuel costs and increased operating efficiency.

Earnings pre-announcements so far by CSX and Union Pacific have focused mainly on the impact of disruptions from the recent hurricanes in the Gulf Coast. Other railroads are also seeing volumes drop, especially as shipments of lumber and other construction materials have fallen off as housing starts have declined.

FedEx's earnings for the first quarter of fiscal 2009, which ended on Aug. 31, were in line with the freight company's upwardly revised estimates as higher fuel surcharges and supportive foreign exchange rates helped offset a 3.3% decline in average daily package volumes and a 9.1% drop in average daily freight volumes.

The surge in tonnage that trucking companies enjoyed toward the end of June quickly reversed in July and most of August as soaring prices of fuel, copper, and other commodities forced domestic manufacturers to stop ordering materials, says Donald Broughton, senior transport analyst at Avondale Partners.

But with commodities prices coming back down since August, "we're seeing domestic manufacturing beginning to produce products again," and truck tonnage has picked up, he says. He thinks the general theme for the third quarter, however, will be one of slightly softer demand, though truckers "have gotten a little bit of a windfall in fuel surcharge collection this quarter."

Declining trucking volumes lasting longer than three months have predicted six of the last eight recessions in this country, typically three to five quarters ahead of time, according to Broughton. Even though an official recession has yet to be called in the latest downturn, he points to a drop in truck tonnage that began in late 2006 and continued through 2007. The fact that tonnage has been building for much of this year bodes well for an economic recovery sometime next year, he thinks.

Warehouse Clubs

Although inflated gasoline and food costs were enough to send consumers into hiding until a few weeks ago, discount retailers like the warehouse clubs have benefited from the cash crunch. The latest quarterly results for industry giants like Costco and BJ's Wholesale Club could continue to provide hints about the state of the economy, but the focus should be on sales volumes rather than profits, which can be adversely affected by unusual cost factors, says Doug Roberts, chief investment strategist for ChannelCapitalResearch.com in Shrewsbury, N.J. If discount retailers start having problems, "that may mean people aren't spending at any price," he says.

Continued growth in Costco's revenues has stemmed from the company's merchandising skills and insistence on its "value message in a difficult economy," Stifel Nicolaus analyst David Schick said in a Sept. 3 research note. Same-store sales for Costco's core business -- excluding gasoline and the foreign exchange impact -- rose 5.8% in August from a year ago, slightly above the range over the past 12 months, the note said.

BJ's isn't showing signs of slowing either. BJ's reported a 15.4% gain in same-store sales and a core merchandise gain (excluding gasoline sales) of 7.7% in August, positioning it well for solid earnings, according to a separate Stifel note on Sept. 3. BJ's strength has been in breakfast foods, meats, frozen foods, health and beauty, and household chemicals, while sales of televisions, air conditioners, jewelry, and cigarettes have been weaker.

Community Banks

Regional banks may also shed some light on the health of the economy if they start having liquidity problems, which, until now, have been confined mostly to the large investment and money center banks, says Roberts at ChannelCapitalResearch.com. A big increase in defaults at these smaller consumer banks would offer further evidence that credit problems are spreading from Wall Street to Main Street, he says.

Early delinquencies on residential mortgage and home equity loans -- where payments are 30 to 89 days late -- were rising in the second quarter at most of the regional banks in the Southeastern U.S. that analyst Kevin Fitzsimmons covers for Sandler O'Neill & Partners, and that hasn't abated, he says. Early delinquencies are a leading indicator for loans to migrate into the non-accrual category, where they no longer generate income for lenders.

Banks are saying they're now watching commercial and industrial and auto loans more closely but are not seeing anything very alarming yet, says Fitzsimmons. "The thing we may hear from companies [when they report earnings] in the coming quarter is that while they were very hopeful credit deterioration would remain confined to areas we spoke about before, that with what's happening to the economy...it's going to have an effect on these other sectors as well," he says.

In a Sept. 24 research note for Friedman Billings Ramsey, regional bank analyst Scott Valentin warned of greater losses on commercial and industrial and construction loans over the next year than what many investors may be expecting.

The ongoing, increasingly contentious tussle over the government's massive bailout of Wall Street will remain center stage in the days to come. But investors should keep their eye on other corners of the economy even as the debate rages on.

Bogoslaw is a reporter for BusinessWeek's Investing channel.