“It is a stream of earnings that you buy when you buy a stock. Ultimately everything else is secondary,” says John Authers in the FT. Over the past few years, US earnings have kept climbing despite a less than stellar macroeconomic backdrop. That’s boosted confidence among investors in US equity markets, which in turn set the tone for their global counterparts. But this “pillar of strength” is now “cracking”, says Morgan Stanley’s Adam Parker. After ten quarters of gains, the second quarter of 2012 will see a fall, he reckons.
American earnings fall
Before the second-quarter reporting season got into full swing, companies began to warn that their results would miss expectations – at a rate not seen in over ten years. Société Générale notes that a gauge of optimism among American analysts, tracking the percentage of recent earnings forecast changes that are upgrades rather than downgrades, has slumped to its lowest level since mid-2008.
One problem is that US corporate profit margins have risen to all-time highs. Since margins revert to the long-term average, there is less scope for cost-cutting to boost earnings. On the revenue side, meanwhile, the picture is grim, both domestically and internationally; around half of S&P 500 sales are made abroad. “All three cornerstones of the world economy seem now to be heading into the sand,” says Jeremy Warner in The Daily Telegraph.
In America, “cracks are beginning to emerge” due to the downturns in Europe and China. Manufacturing is shrinking and the sharp slowdown in employment growth is rattling consumers. Retail sales declined for the third successive month in June. The upshot is that growth has probably slowed to an annual rate of 1%.
That’s before large tax hikes and spending cuts, which could lower output by 4%, kick in early next year. Investors can’t count on a gridlocked Congress to reach a deal to avoid the “fiscal cliff” in an election year.
Trouble in China and Germany
China faces a hard landing as it is caught between “stagnant export markets and evident overcapacity in the domestic economy”, says Warner. In emerging markets as a whole, the data keep surprising on the downside and Asian exports are stagnating, adds Morgan Stanley.
The latest data in Europe, meanwhile, suggest that “Germany’s earlier economic resilience is over”, says Capital Economics. The southern European recessions have deepened and emerging-market growth has eased. Consumer spending has also fallen. “As a deepening debt crisis continues to hit international and domestic sentiment”, the export-dependent German economy is set to shrink.
What next?
Unfortunately, there is plenty of potential for economic growth and earnings forecasts to be revised downwards, thus rattling markets further, says Fxpro.com. Citigroup has produced Surprise Indices for major economies. These track whether recent data are coming in better or worse than forecasters have expected. A weighted average of America, China and Europe indices has slipped to its lowest level since the depths of the global financial crisis (see chart).
As far as US earnings are concerned, “you can only have so many things working against you”, says Christine Short of Standard & Poor’s Global Markets Intelligence. S&P 500 firms are facing a deteriorating world economy, a weaker oil price – the energy sector is a market heavyweight – and a stronger dollar.
The earnings picture in Europe, meanwhile, is hardly encouraging. Investors concerned by the darkening outlook can’t count on another sugar rush boosting stocks, as we noted last week. Markets seem to be realising that hurling printed money into an economy where demand is subdued – because the private sector is working off debt – is hardly a miracle cure. The upshot is that we now look set for another global market downswing.