Corporate profits

The corporate earnings sauce train goes off the rails

  • As the second quarter earnings reports begin to come out, expectations are once again low.
  • Analysts say that’s because the increase in tax cuts last year is fading and the trade war has spooked businesses.
  • A second consecutive quarter of declining profits, for the first time since 2016, is possible.

New York – Well, it died down quickly. Profits surged for U.S. companies last year, with growth exceeding 20% ​​for S&P 500 companies through much of 2018. the cut shake fades and trade war concerns persist.

Companies are lining up to tell investors how much they earned in the spring, and expectations are once again low. Some data analyzers predict that S&P 500 companies will post a second straight quarter of declining profits, which has not happened since 2016. Others say large companies will make modest gains, but all agree that the growth fell sharply compared to a year ago.

This is important because stock prices tend to follow the path of long-term corporate earnings growth. Stocks have hit record highs this year as the Federal Reserve has moved from raising interest rates to possibly lowering. This has encouraged investors to pay more for every dollar in profit generated by a business. But unless the companies are generating more dollars in profit, it will be difficult for stocks to continue to climb.

Even though companies are showing slightly positive growth in the second quarter, “whether that will be enough to support stock prices in the absence of a trade deal is questionable,” said David Joy, chief market strategist at Ameriprise.

Beyond the drop in tax cuts

One of the main reasons for declining profits is that companies no longer benefit from the first year of lower tax rates. But other factors are weighing on growth as well, starting with the trade war.

Manufacturing growth has slowed around the world, and companies are increasingly cautious about their spending given the uncertainty of the U.S.-China trade dispute. Seven rate hikes by the Fed over the past two years are also having a dampening effect on the economy.

Labor costs are also increasing for companies. While this is good news for workers getting raises, it is hurting the company’s bottom line.

This is the case even though the Federal Reserve President Jérôme Powell told a House committee yesterday that he did not yet see much of an impact for workers. “We have no basis or no evidence to call it a hot job market,” Powell said. “We have wages and benefits increasing by 3%, which is good because it was 2% a year ago, but 3% barely covers productivity increases and inflation. “

And companies certainly have a lot of room to raise wages, as they keep near record profits for every $ 1 they sell. But the trend is expected to continue to decline this year, according to Goldman Sachs strategists.

Tech and web stars in danger

Investors don’t seem to care much about the threat to earnings, at least not yet. This is evident in how stocks of low-labor-cost companies have recently fallen behind the rest of the market, but Goldman Sachs strategists point out that wage growth has reached its fastest level. last year in over a decade.

The companies most at risk may also be those that have generated much of the market’s gains in recent years: the big stars of technology and the Internet. According to Credit Suisse, Apple, Facebook and Google’s parent company Alphabet are among the companies expected to weigh the most on Q2 profit margins for the S&P 500.

For the third quarter, analysts are forecasting a further year-over-year decline in the S&P 500’s earnings per share, this time by 0.5%, according to the FactSet tally. Analysts said profit growth would not return until the fourth quarter, where it could reach 6.3%.

The S&P Dow Jones Indices analyst tally indicates earnings growth will be modest in the third quarter before surging in the final three months of 2019.

Artificial fuel for earnings per share

The numbers would likely be even more daunting if companies weren’t spending hundreds of billions of dollars to buy back their own shares. These buybacks allow CEOs to spread weak earnings growth over a smaller number of stocks that investors still own, meaning earnings per share are growing faster than overall earnings.

Lately, bad news about the economy has ended up being good news for the stock market. Weaker-than-expected reports in the labor market and other areas of the economy in June, for example, boosted stocks as they raised expectations for the Fed to cut interest rates.

But when profits start to fall, warning lights flash on Wall Street. Market psychology has historically changed when profits fall, according to François Trahan, a strategist at UBS, who pointed to market movements in 2001 and 2008.

It was then that the bad news for the economy turned bad again for the stock market.