Sluggish corporate earnings could be another warning sign for the economy.
Two weeks ago, stocks were hitting record highs daily, juiced by expectations for a steroid-like boost to the market in the form of a Federal Reserve interest rate cut later this month.
Last week the market stalled, mostly because of mixed quarterly results from corporations and speculation that the Fed may not trim rates as much as anticipated. The stock market gave back the prior week’s gains as investors digested the reality that the market’s fundamental pillar – earnings growth – has been lackluster and may soon signal a possible recession down the road.
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The Standard & Poor’s 500 index is still only about 1% below its record close of 3,014, and the Dow Jones industrial average remains above the 27,000 milestone it crossed July 11.
Yet with second-quarter earnings season underway, analysts are nervously waiting to see if the final results will deliver a second straight quarterly drop in corporate profits. Those surveyed by FactSet reckon the earnings of S&P 500 companies declined 1.9% in the April-June period from a year earlier. That’s based on a blend of their pre-earnings season estimate and actual results of the 16% of companies reporting so far.
Why the concern over back-to-back declines?
Two consecutive quarterly decreases would represent an earnings recession, which typically – but not always – foreshadows an economic recession within a year or two. Companies whose profits are squeezed tend to pull back hiring and investment.
Weak earnings also would raise questions about whether stocks are overvalued.
“The Fed’s recent signals of an interest rate cut later this month should not be celebrated if it’s accompanied by an earnings – and possibly an economic – recession in the U.S.,” Mike Wilson, Morgan Stanley’s chief equity strategist and one of Wall Street’s most bearish analysts, said in a podcast this week.
Wilson, in fact, is forecasting an earnings recession.
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Keep it in perspective
But let’s put the numbers in perspective. The past five years, actual S&P 500 earnings have topped analysts’ estimates by 4.8% on average, FactSet figures show. If that occurs this quarter, it would mean a modest 2% to 3% advance for the group of large public companies.
“We’re not going to see a decline” in earnings in the second quarter, says Brad McMillan, chief investment officer at Commonwealth Financial Network.
The companies reporting earnings so far have notched 4.1% growth, with 79% beating estimates. It’s still early, of course, and some sectors have disappointed, with materials, technology and energy leading the poor performers.
A slight earnings drop wouldn’t necessarily be cause for concern, analysts say. Earnings dipped just 0.3% in the first quarter from the year-ago period, according to FactSet. And that’s largely because the tax cut spearheaded by President Donald Trump inflated profit growth last year, McMillan says.
Even a sharp second-quarter earnings fall would not necessarily mean a recession is in the cards. Earnings slumps in 1998 and 2015-2016 weren’t followed by economic downturns. In the latter, a slide in commodity prices and a rising dollar hurt corporate profits but aided consumer spending – which makes up about 70% of economic activity, says Jim O’Sullivan, chief US economist of High Frequency Economics. That’s because a strong greenback means less income when multinationals bring overseas sales back to the U.S. but cheaper imports for Americans.
A similar dynamic may currently be at work. Job growth has slowed but remains solid; wage increases generally have picked up; and a report last week highlighted strong retail sales in June.
Meanwhile, a strong dollar and slowing global economy have hurt the profits of multinationals. About 40% of S&P 500 companies’ revenue comes from abroad, according to Howard Silverblatt, senior industry analyst for S&P Dow Jones Indices. And the U.S. trade war with China has created uncertainty that has dented business confidence and spending, further crimping corporate earnings and economic growth.
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Still, “As long as consumers are still spending, we’re not going to have (an economic) recession,” says McMillan of Commonwealth Financial Network.
Yet most economists surveyed by the National Association of Business Economics are forecasting a recession by next year. An earnings skid would be just the latest red flag, along with an inverted yield curve – yields on 3-month Treasury notes have been higher than those of 10-year bonds, underscoring a dim outlook – and slowing employment gains.
What does this mean for stocks?
S&P 500 shares appear pricey at 17.1 times projected earnings over the next 12 months, above the average 16.5 multiple the past five years, according to FactSet. Lackluster earnings are likely to underscore the frothy values, possibly spooking investors.
McMillan, however, says stocks are fairly priced in light of a likely Fed rate cut this month and the prospect of further reductions over the next year aimed at heading off recession. That’s because lower rates tend to drive investments from low yielding bonds to equities, giving them a justified premium.
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Chris Zaccarelli, chief investment officer of Independent Advisor Alliance, believes stocks, which have been volatile since last fall, will continue to trade sideways until a resolution of the trade war eases business uncertainty and unleashes investment. That would provide a jolt to both earnings and the economy, he says.
Fed rate cuts “will only lift equity prices so far, and for so long, if economic activity does not accelerate, revenue growth does not firm, and earnings growth does not resume,” says David Joy, chief market strategist of Ameriprise.