America’s corporate earnings bubble hisses air

Amazon warehouse worker © Jeff Spicer/Getty Images
Amazon’s wage hikes reflect higher labour costs, which are squeezing profit margins

“America Inc. mints $1bn every five hours,” says The Economist. The long bull market has rested on booming corporate profits, which are up 455% over the past 25 years. A third of every dollar made by firms worldwide is now accounted for by US businesses. Yet “the era of relentlessly expanding profits is under threat”.

Last week marked the start of the second-quarter earnings season, the multi-week period that sees US firms report their most recent profits. The forecasts are gloomy. At the start of the season FactSet data predicted a 1.9% year-on-year decline in the average [second-quarter] earnings of S&P 500 companies. Because earnings fell 0.3% in the first quarter on a year before – mainly due to Trump’s corporate tax cuts falling out of the annual comparison – that has sparked talk of an “earnings recession”, defined as two consecutive quarters of falling earnings.

The final results will be better than expected, says Justin Lahart in The Wall Street Journal. Wall Street tends to “lowball” estimates so that it can then celebrate an “earnings beat”. Yet even so the final figures “are unlikely to fit anyone’s definition of good”.

The market is not the economy

The corporate earnings slowdown is driven by powerful forces, says The Economist. The US-China trade war is bad news for America’s big firms, which derive a big slice of their profits from abroad. With unemployment close to a 50-year low, labour costs are rising: witness Amazon’s decision last year to pay its workers $15 an hour. That squeezes margins.

The question now is whether the threatened earnings recession could trigger a recession in the real economy, says Paul Davidson for USA Today. “Companies whose profits are squeezed tend to pull back hiring and investment.” Another worry is that many American businesses cannot afford to see their earnings sag, says The Economist. “As a share of GDP, corporate debt is nearly where it was before the subprime bubble burst in 2008.” That leaves many overly leveraged businesses dangerously exposed.

Actually, the US economy seems pretty robust, says Lahart. The corporate earnings slump has been driven by slowing global trade and a strong dollar, which chip away at the value of overseas sales. But don’t confuse American business profits with the American economy. For consumers, rising wage growth and low inflation bode well.

Even more expensive stocks

The big problem for investors is that sluggish earnings growth leaves American equities looking very overpriced. On 16.7 times forward earnings the S&P 500 is trading at a 16% premium to the historical average, says Jack Hough for Barron’s. Note, however, that some big falls in the tech sector have dragged down the average earnings forecasts. That is bad news for investors in index funds. But the typical – or “median”– company is forecast to register healthy profit growth of 6.6% this quarter. So careful stockpickers may yet do well. “This old bull market might be losing a step, but it’s still on its feet.”