United States: The Earnings Recession

It’s official: An earnings recession is now underway. That’s true whether the metric is S&P 500 operating earnings or corporate profits that economists project. Measured by the S&P 500, our strategy team estimates that earnings per share declined by 2.8% in the third quarter compared with a year ago. And while statisticians estimate that the broader gauge in the US National Income and Product Accounts (NIPAs) rose by 2.7% over the same period, there are clear signs of deterioration pointing to weaker future results. Indeed, I think a squeeze on profit margins and slower volumes are doubly crushing earnings growth. Wall Street analysts have begun to get the message: As recently as November 2, the consensus forecast for fourth quarter S&P 500 operating earnings was for a gain of 8.4%. My colleague Bill Smith calculates that the consensus now predicts a gain of 2.2% in the fourth quarter. And the team’s S&P 500 earnings revision factors signal further downward movement over the next several weeks.

The key questions: How deep will the earnings downturn be, how long will it last, and what are its implications for the economic outlook? In my view, it promises to be nasty. High operating and financial leverage argue for a significant contraction in earnings even if the economy skirts recession. Even with moderate growth, I think earnings will contract in 2008, but the margin squeeze will magnify the downside risks to earnings by a multiple of four or more. In other words, in a 1-2% GDP economy, I think earnings may contract by 2-5%, but in a 0-1% growth environment, they may decline by 5-15%. Moreover, the earnings recession carries downside risks for the economic outlook: Pressures on profit margins will contribute to weaker capital spending and perhaps depress hiring.

A squeeze on profit margins, one I’ve long anticipated, is the key factor driving the earnings downturn (see “Corporate Profits: Leaving the Sweet Spot,” Global Economic Forum, October 6, 2006). Operating leverage working in reverse, and rising costs, dwindling pricing power, and deteriorating credit quality will all weigh on margins. With domestically-generated earnings already contracting in the third quarter by 4% from a year ago, even a solid contribution from growth in earnings abroad and the translation effect of a weaker dollar are unlikely to offset the effects of domestic margin compression. Here’s why.

First, the analytics. I have long maintained that the combination of slower growth and high operating and financial leverage in Corporate America make a contraction in earnings unavoidable even if the economy skirts recession. Lower marginal but higher fixed costs have increased operating leverage. Corporate America’s ability to exploit that leverage propelled earnings to record levels when growth was healthy. Strong increments to revenue went straight to the bottom line. Financing the boom with debt and buying back stock increased financial leverage and, of course, raised earnings per share. Bill Smith estimates that corporate buybacks may have added 250 bp to S&P earnings gains in 2006 and 300 bp this year.

But leverage — both operating and financial — works both ways. Slower growth means that operating leverage is working in reverse, with decreases in revenue going right to the bottom line. In addition, slower growth has trimmed operating rates, reducing pricing power. In manufacturing, for example, operating rates have declined by a percentage point over the past year. Not only does that mean slower top line growth, but the loss of pricing power drops straight to the bottom line. Thus, the acceleration in nonfarm unit labor costs to 4.3% in the year ended in the third quarter is pressuring margins rather than prices. And retailers with extra capacity can’t pass through the rising cost of imports as the dollar declines (see “Is a Weaker Dollar Inflationary?” Global Economic Forum, November 16, 2007). Partly as a result, our retail team expects margins to decline through much of 2008. Moreover, higher financial leverage boosted debt service in relation to cash flow, and now investors demand higher premiums to take on escalating credit risks, squeezing profits further. Finally, asset write-downs and provisioning for loan losses will significantly erode earnings in financial services (for details, see Abhijit Chakrabortti, Jason Todd and William Smith, “No Country For Old Men,” December 3, 2007; this will affect the S&P 500 measures; in NIPA-based profits metrics, such capital losses are excluded).

To be sure, there is some offsetting good news, not surprisingly from overseas. Growth abroad — and the higher oil prices that come with it — are powerful engines for US earnings. The leverage factor in this case could be as high as 5 to 1; that is, a percentage point improvement in global growth would yield an extra 5 percentage points of US earnings growth. According to Macroeconomic Advisers, global nominal GDP excluding the US rose by 6.7% over the past year. Measured by the NIPAs, earnings of US affiliates abroad jumped by nearly 20% over that period. Such earnings amounted to a record 31.5% of overall earnings in the third quarter of 2007; S&P measures show a similar share. Importantly, that’s double the share of twenty years ago – the last time strong global growth consistently contributed to growth in the US. Consequently, the global impact on earnings today has doubled over the past two decades as US direct investment has spread abroad. Moreover, we think that for the first time in two decades, stronger global growth will consistently lift US growth through improved US net exports. Empirical work has long supported the idea that improving growth is several times more powerful for exports than a similar-sized percentage-point change in relative prices. That will also boost US earnings.

In addition, a weaker dollar, if sustained, could also support US earnings through two channels. First, it is already translating US companies’ overseas results in euros or yen into more dollars. On a trade-weighted basis, the dollar has declined by 6.9% from a year ago, and our empirical work suggests that a 10% decline would boost US earnings from abroad by at least 3% and as much as 6%, boosting overall earnings by 150 bp. So the 6.9% decline in the dollar may have boosted overall earnings by more than100 bp. It’s reasonable to expect those effects to continue well into 2008. In addition, a weaker dollar at the margin will help US companies recapture market share. That real US exports rose by 9.8% in the year ending in September is encouraging in that regard. Unfortunately, these earnings tailwinds won’t offset the decline in domestically-sourced profits.

How long will the earnings downturn last? If the economy skirts recession and growth recovers, the downturn could be short-lived, and the middle of 2008 may mark the deepest decline in profits when compared with a year ago. But even the mildest of recessions would probably defer positive comparisons until 2009. That’s because operating leverage will have to work positively to boost margins again, and that boost will be slow until the economy itself accelerates.

Financial markets are beginning to pay attention to these developments, but an earnings recession is not in the price. Lower interest rates won’t bail out equities on a sustained basis, at least not yet, because they are the product of a weaker economy. Thus, earnings disappointments likely will drag equities lower.

The earnings downturn carries clear-cut downside risks for both markets and the economy; a serious profit squeeze and lower stock prices would turn what had been a virtuous economic circle into a vicious one. Reduced cash flow and declining equity values will dampen “animal spirits” and capital spending, and may weigh on hiring (see “Capex Recession Ahead?” Global Economic Forum, October 1, 2007).

Despite this litany of negatives, it is important to remember that the coming margin squeeze follows a five-year period of margin expansion that took them up 500 basis points to record highs. And unlike the late 1990s, margin compression this time around may well be relatively short-lived; excess capacity and hiring are not weighing on returns and pricing power to the same degree, so margins won’t be crushed as in 1997-2001. While investors must first traverse the earnings downturn as the slowdown compresses margins next year, renewed growth in 2009 will help them expand again.

By Richard Berner New York
Morgan Stanley
December 3, 2007