This US earnings season the data from the frontline is about to confirm the broader economic narrative: things aren’t so great.
How that plays out in financial markets and whether we begin to see meaningful contagion is perhaps the more interesting question.
US companies have begun their quarterly ritual of reporting earnings, and though we are early in the process, already the themes may be emerging: lower revenues, profit margins under pressure and a fondness among companies to blame the strong dollar or weakness abroad in places like China.
Less than 10% of US companies have yet reported, but according to data from earnings tracker FactSet the majority of companies citing a negative factor on calls discussing earnings with investors cited the stronger dollar, with a substantial minority blaming weakness in Europe or China.
“As global growth decelerates, corporate earnings growth should decelerate,” Stephen Jen of hedge fund firm SLJ Macro Partners wrote in a note to clients.
“We will likely see unimpressive micro data (corporate earnings) to confirm the troubled macro narrative of the world. The ‘bad-news-is-good-news’ dynamics will not likely last much longer.”
That idea, that poor news could be good for markets for risky securities like equities, is based on the idea that weakness makes it more likely that the Federal Reserve waits longer to hike interest rates, or makes other attempts to ameliorate the economy.
Aluminum company Alcoa hit all of the expected blue notes with its earnings release last week, reporting a double-digit decline in sales, combined with issues caused by dollar strength and a huge increase in production by competing Chinese firms.
Firms in general look vulnerable to regression back towards more historically typical levels both of profits and margins. With S&P 500 profits at record highs, a failure to expand top-line sales or any type of wage pressure are almost sure to compress profit margins.
As well, while years of corporate share buybacks flatter earnings per share figures, they often have served to mask weakening in firms’ underlying franchise, or a reluctance to invest in new markets or products.
Some areas, such as energy firms, are almost sure to show contraction in sales and margins but others too, notably banking, are also in the firing line. A rocky August in global financial markets is likely to have hit revenues from capital markets activities, with many bond and share issues delayed. At the same time, the Fed’s decision not to raise rates means that banks still face only scant compensation from the extra they can charge borrowers above what it costs them to raise money, called net interest margin.
Lack of contagion
Given ructions in China and dislocations in financial markets over the summer in some ways it is remarkable we’ve had so little contagion, economically or in securities.
Emerging markets, particularly Brazil, have been hit very hard, as shown by the fact that MSCI’s index of emerging market currencies is down more than 8 percent in a year. Riskier parts of the bond market have also suffered. The extra interest a high-yield, or junk, borrower must pay to raise funds is 1.65 percentage points higher today than a year ago. While high-yield borrowers are often energy firms, which are rightly causing lenders default worries, better positioned borrowers with good credit ratings are now having to pay extra too.
Financial markets, even with a sell-off in equities, have remained, by and large, reasonably calm, with a signal lack of the sort of panicked contagion often seen in the early stages of downturns.
Market strategist Ed Yardeni, of Yardeni Research, argues that most of the speculative excesses in the latest round have been provided by capital markets, or privately, rather than through commercial banks.
“So the losses aren’t impairing the banking system this time,” Yardeni wrote in a note to clients.
“Rather, they are simply reducing the returns on portfolios that own the bad debts. Most of them are large institutional portfolios, so the negative wealth effect isn’t depressing consumer spending or having any other significant contagion effect on real economic activity.”
Still, by definition a slow economy causing an earnings turndown should in theory have its own economic consequences. Those may not be a loss of faith in the financial system, or even a large retreat from risk taking.
Instead, equity investors may have to re-do their calculations. If the outlook, as it seems to be, is for continued low interest rates and low economic growth, then we may have reached the end of the line for margin growth or for the magic of buying back shares to stoke interest in stocks.
Perhaps a routine earning season is more of a turning point.
(At the time of publication James Saft did not own any direct investments in securities mentioned in this article. He may be an owner indirectly as an investor in a fund. You can email him at jamessaft@jamessaft.com)
