US Corporate Profits: Under Greater Scrutiny

US Corporate Profits: Continued Weak Top-line Performance in Q3

We have just completed an important week for corporate profit results for S&P500 companies. The percentage of reporting companies beating EPS estimates remains high (71%), but the percentage of companies beating top-line estimates remains disappointingly low at 36%. The weakness in top-line performance is a continuation of Q2’s dynamics and matches the level recorded in 2009 Q1. The percentage of S&P500 companies beating top-line estimates has averaged 56% over the past 4 years. The weakness in top-line performance is concentrated in the utilities, industrials and consumer staples sectors. Both companies and analysts have guided expectations lower for Q4. The global macroeconomic backdrop still operates as a significant headwind for corporate profits growth. The latest expected year-over-year change in S&P500 operating EPS for Q3 is -1.2%. If this expected change materialises, it would represent the end to eleven consecutive quarters of positive operating EPS growth.

High Negative Guidance for Q4

The incidence of negative guidance for Q4 is very high: 48 companies have issued negative guidance, while just 12 have issued positive. This means that 77% of companies offering any semblance of guidance offer negative guidance. This is well above the long-term average of 61%. The figure of 77% is, however, similar to the 78% negative guidance incidence reported at the same stage of Q2’s reporting season. The bulk of the negative guidance is concentrated in the information technology, consumer discretionary and industrial sectors.

The market’s reaction to the profile of Q3 results has been fundamentally different to that of Q2. It appears that corporate results are being more robustly scrutinised in Q3, whereas monetary policy considerations in both the US and Europe dominated any thoughts about corporate performance during Q2’s reporting season.

Global Economic Implications of Weak Top-line Performance

The global economic implications of companies missing sales expectations may be considerable: companies could become very cautious about building inventories and increasing hiring. There is also the issue of where the sales weakness is emanating. Europe’s recession should imply that US companies with direct foreign investment exposure to the region will be under pressure to reduce the breakeven level of sales by lowering headcount in Europe. Weakness in European aggregate demand is also having an impact on US labour demand via subdued export sales. Weaker overseas demand is not just confined to Europe: emerging markets, notably China and India, have been exhibiting slower growth rates. For companies that have recently committed significant capital to emerging markets, the slowdown presents a potentially challenging task of justifying the capital allocation.

Another Round of Cost Reduction Programmes

The contrasting performance between top-line and bottom-line “beats” during Q3 would suggest that companies have been keeping an excellent lid on costs. The global economic slowdown has intensified pressure on multinational companies, in particular, to undertake further cost containment. There will be implications on all components of the cost structure, particularly labour. Dow Chemical, DuPont, AMD and Ford have, for example, all recently announced significant cost containment programmes, involving headcount reductions.

The high degree of uncertainty attached to the future global economic backdrop is a valid excuse to engage in cautious cost management, but it is naïve to believe that the passage of the US elections will suddenly remove that uncertainty. There are important political changes in China next month that could result in a recalibrated economic relationship between the US and China.

Excessive Reliance on Foreign and Financial Profits

The impressive recovery in US corporate profits since the end of the Great Recession is largely attributable to two sources, namely the financial sector and foreign-sourced profits. The recovery in financial profitability owes much to the efforts of the Fed. The decision to invoke a third tranche of quantitative easing will help to further underpin the profitability of the financial sector.

The Fed can have an indirect impact on foreign-sourced profits if monetary policy has a major effect on the exchange rate. The expansion of the Fed’s balance sheet has generally been synonymous with a weaker exchange rate. This link has, however, been tested in 2012 due to the intense economic and financial stress in the eurozone: the dollar appreciated nearly +13% versus the euro between 2011 Q3 and 2012 Q3. This represents a reversal to 2011’s dynamics when the dollar was weak relative to the euro and other major currencies, helping to boost revenues.

The biggest source of weakness for foreign-sourced profits is, however, shortfalls in aggregate demand outside of the US. Austerity programmes in Europe have taken their toll on aggregate demand, as testified by high unemployment. The chances of a rapid turnaround are low, implying that Europe will remain a drag on US corporate profits growth.

US Political Uncertainty and the Fiscal Cliff

Companies have repeatedly cited the business uncertainties they face due to the potential fiscal cliff scenario. The full-blown fiscal cliff scenario produces an unprecedented tightening of fiscal policy equivalent to 4% of GDP. The US would enter recession under this scenario, even if the Fed hurriedly attempted to infuse further monetary accommodation into the economy. An Obama victory would probably see an early attempt to delay the onset of fiscal tightening. A Romney victory poses a more interesting scenario in that the “lame duck” Congressional session after the election could see the Democratically-controlled Senate block any attempts to delay the tightening of fiscal policy. Furthermore, the ability to delay fiscal policy tightening under a Romney victory will also depend on who controls the Senate after the election. If the Democrats retain control of the Senate, then some fiscal tightening will occur.

The Impact of the Fiscal Cliff on Earnings Expectations

Should the chances of a recession caused by unprecedented tightening of fiscal policy increase, then earnings expectations for 2013 will need to be quickly recalibrated. Currently, both bottom-up and top-down S&P500 earnings expectations still forecast growth for 2013 S&P500 operating EPS. The biggest threat to risky assets would be negative recalibration of earnings expectations for 2013 due to increased risks of recession. While the Fed would undoubtedly increase asset purchases if recession risks rose, it is doubtful lower discount rates could offset falling corporate profit expectations in terms of trying to support risky asset prices.

The current structure of earnings expectations for 2013 makes interesting reading: S&P500 operating EPS growth in 2013 is expected to be around +10.4%. Two of the strongest sectors expected in 2013 are materials (+22%) and consumer discretionary (+14%). They are also inherently cyclical. A major upward revision to recession risks would force downward EPS revisions to the aforementioned sectors. From a valuation perspective, however, neither the materials nor consumer discretionary sectors are trading on historically expensive 12-month forward P/E ratios. In fact, most of the S&P500 GIC sectors are trading at below historic average 12-month forward P/E ratios. This could soften the blow of lower earnings expectations to risky assets. The notable exceptions are the expensive, “defensive” sectors of utilities and telecom services. This valuation anomaly has been driven by the continued search for yield.

Summary and Conclusions

The incidence of S&P500 companies beating Q3 EPS estimates remains high, but top-line performance relative to expectations continues to disappoint. Analysts and companies have started to lower expectations for Q4 EPS growth.

The incidence of negative guidance for Q4 is very high. Corporate results during Q3 are being more thoroughly scrutinised versus Q2’s reporting season.

Continued weak top-line performance could make companies even more cautious about building inventories and hiring. The global economic slowdown has increased pressure on US multinationals to undertake restructuring measures to reduce the breakeven level of sales. The passage of the US elections may not entirely remove the macro uncertainty that has plagued the corporate landscape. There are important political changes happening in China as well.

The recovery in US corporate profits owes much to the financial sector and foreign sources. Continued quantitative easing by the Fed will help to underpin the profitability of the financial sector, but weakness in overseas markets, notably Europe, will continue to be a headwind for aggregate profits growth.

The biggest threat to domestic non-financial profits is the possibility of a full-blown fiscal cliff scenario. This outcome would produce a recession and require a major recalibration to 2013 earnings expectations. A choppy period for risky assets would ensue. The current below historic average P/E valuations could, however, help to soften the impact for many S&P500 GIC sectors.

About Said Desaque

I'm a professional economist in financial services, with a keen interest in international relations, along with their implications for economic development.

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