This week, we get the first US company reports on earnings for the second quarter of 2019. And it looks as though there will be the first back-to-back drop in overall earnings since the mini-recession of 2016. S&P 500 companies are expected to report an average earnings fall of 2.8 per cent in the second quarter, according to data provider FactSet, following a 0.3 per cent dip in the first three months of the year.
Much is made of the large profits that the top tech companies, the so-called FAANGS, make. But this hides the situation for the majority of US companies. Those with a market value of $300m to $2bn look set to experience a 12% drop in earnings from this time last year after a 17% drop in Q1 2019. So small to medium size American companies are suffering a sharp profits decline.
And even with the larger companies, profits are not as good as portrayed. That’s because earnings per share have been boosted by the large companies buying back their own shares (same earnings but with less shares available). Net share buybacks are expected to contribute 2.1 percentage points to EPS growth in the second quarter, according to analysts at Credit Suisse. US companies snapped up more than $1tn of their own stock last year, a record figure, driven by the Trump tax measures.
Underlying this decline in profits are higher wage costs as fuller employment forces companies to concede wage increases to keep skilled workers – it’s a different story with the less skilled outside the tech sector. Also the cost of other non-labour inputs (energy, raw materials etc) are rising. So profit margins (profits per unit of production) are falling. Analysts expect non-financial companies to report net margins of 10.8 per cent in the second quarter, down from 11.5 per cent in the year-ago quarter, according to figures cited by BofA analysts. “We have been highlighting risk to margins from rising input costs for companies that don’t have pricing power, as well as for labour-intensive companies and sectors amid rising wages, and we expect full-year net margins to contract to 11.2 per cent in 2019 ex-financials from 11.7 per cent in 2018,” they add.
The strong US dollar has also meant that US export companies are finding it more difficult to sustain sales growth. S&P 500 companies are forecast to report a 3.7 per cent increase in revenues, which would be the weakest growth since the third quarter of 2016.
Materials companies, the sector with the most sensitivity to China and the fallout from the ongoing trade war between Washington and Beijing, are expected to have had the toughest time in the second quarter. DuPont and Freeport-McMoRan are expected to be the biggest contributors to the sector’s earnings slump, according to FactSet. The sector is projected to report a 16 per cent year-on-year decline in earnings and a 14.9 per cent drop in revenues.
Most important, even the tech sector will experience an 11.9 per cent fall in earnings and a 1.1 per cent drop in revenues. This is important because it is this sector above all that has driven profits growth in American companies over the period since the Great Recession. If the FAANGS show a decline on profits, then American capital is in trouble.
As James Montier, the post-Keynesian economist at GMO, the large asset fund manager, points out, real earnings growth in the corporate sector has been below the rate of real GDP growth even after the significant boost from the financial engineering from share buybacks. According to Montier, when you dig down into the market you find that a staggering 25-30 per cent of firms are actually making a loss.
In Montier’s view, “the US is witnessing the rise of the “dual economy” — where productivity growth is reasonable in some sectors, and totally absent in others. Even in the sectors with good productivity growth, real wages are lagging (wage suppression is occurring). All the employment growth we are seeing is coming from the low productivity sectors. On top of this, the paltry gains in income that are being made are all going to the top 10%. This is not what a booming economy should feel like.”
There is a segregation of the US economy into sectors with reasonable productivity growth and those with no productivity growth at all. The single biggest driver of productivity is manufacturing, with information and wholesale trade scoring respectably as well. On the least productive side there’s transportation, accommodation, education and healthcare. What’s more, in the laggard group, zero productivity growth has gone hand in hand with zero real wage growth.
Not that this historic non-profitability has stopped investors from piling into even more loss-making opportunities. According to Montier, some 83 per cent of IPOs (new stock issues) this year have come to the market with negative earnings. He stresses:”This is a higher percentage than that seen even at the height of the tech bubble!”
So the stock market rolls on upward to more record highs, floated by the expectation of yet more cheap or near zero cost money from the Federal Reserve. But beneath the hype, the reality is that profits are falling for many US companies, and over a quarter are making loss – in effect, they are ‘zombie companies’.
It is the same story in Europe and Japan. If the profits crash materialises and is sustained through the year, a sharp fall in investment and eventually employment and spending will follow, despite the stock market boom – in effect a new recession.