Potential earnings recession could defy growth outlook

Corporate profits are under pressure and there are no new tax cuts to cushion the blow

Fears of a looming U.S. recession have subsided, with investors taking comfort that the Federal Reserve will continue to support economic growth.

But warning signs keep flashing about the shaky fundamentals of the economy and therefore the stock market. The latest alarm bell is that Wall Street analysts are slicing their forecasts for how much big companies will earn in the months ahead.

Halfway through the first quarter of the year, analysts now expect profits of companies in the S&P 500 to decline by 1.7 per cent from the same period in 2018, according to data from John Butters, senior earnings analyst at FactSet.

Corporate profits are by no means a perfect proxy for the health of the U.S. economy, the world’s largest. But they exert heavy influence over the direction of the stock markets.

In the first nine months of 2018, for example, an unexpected gusher of company earnings — up 20 per cent from their previous levels — powered the S&P 500 to record highs. The fat bottom lines allowed investors to look past both the prospect of a trade war between the United States and China and a number of data points that showed large foreign economies, including Japan and Germany, losing steam.

It isn’t unusual for analysts to pare back their earnings forecasts over the course of a quarter. Corporate executives offer guidance about how their businesses are performing, and a variety of macroeconomic data helps analysts hone their profit projections. During the past decade, analysts’ profit forecasts have declined on average by 3.7 per cent over the course of a full quarter.

On Dec. 31, analysts expected companies in the S&P 500 to earn, on average, $40.21 (U.S.) per share. Today, that estimate is $37.95 — an unusually large 5.6 per cent drop, according to FactSet.

If companies’ first-quarter performances turn out to be as weak as analysts expect, the United States will be on track for what the financial community calls an earnings recession, which occurs when corporate profits shrink for two straight quarters.

That looks increasingly likely to happen in the first half of this year. Analysts expect earnings to rise by just 1.2 per cent in the second quarter. That forecast is likely to fall, perhaps into negative territory, as more companies disclose their results and analysts update their forecasting models.

Corporate profits this year were always going to face a difficult comparison with 2018. The combination of a strong U.S. economy and the newly reduced corporate tax rates led earnings to jump more than 20 per cent.

But profits are now under pressure on multiple fronts and there are no new tax cuts to cushion the blow — an ill omen for the stock market, if not the broader economy. Rising costs and a slowing global economy have caused many S&P 500 companies to reduce their profit outlooks.

That is especially true among technology companies. Analysts expect them to report a nearly 10 per cent decline in profits in the first quarter, the biggest decline of any sector in the S&P 500.

Much of the blame for the tech sector’s declining fortunes rests with Apple. Since the end of 2018, analysts have cut by nearly 19 per cent their estimates for how much Apple will earn in the first three months of 2019.