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 How that plays out in financial markets and whether we begin to see
meaningful contagion is perhaps the more interesting question.
U.S. 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 percent of U.S. 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.
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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 anydirect
investments in securities mentioned in this article. Hemay be an
owner indirectly as an investor in a fund. You canemail him at
jamessaft@jamessaft.com and find more columns at http://blogs.reuters.com/james-saft)(jamessaft@jamessaft.com))
(Editing by James Dalgleish)
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