I IT’S MID-JULY, therefore the football season in England will start soon. You probably didn’t notice it was over. The earnings season, when listed companies in America reveal their quarterly results, unfolds with equally tedious frequency and also seems to never end. The second quarter season that kicks off this week, however, should stand out. State-owned enterprises as a whole are expected to post the largest increase in profits since the rebound from the Great Recession of 2008-09.
Earnings optimism has driven stock prices higher over the past year. But the financial markets are relentlessly focused on the future. And with windfall revenues already in the bag, they now have less to look forward to. A rally in bond prices since March and a massive sell off in some cyclical stocks suggests a slowdown GDP growth. A plausible argument can be made that the earnings outlook could deteriorate as quickly as it has improved.
Start with bottom-up earnings forecasts from company analysts. They expect earnings per share for the MSCI The global stock index will rise 40% in 2021, according to FactSet, a data provider. This is much higher than at the start of the year, when the forecast was around 25%. A slowdown to a growth rate of 10% is expected in 2022. Again, forecasts tend to start at 10%, a well rounded figure, before being revised upwards (as in 2017 for example) or on the downside (as in 2019) as the news arrives.
Profits fluctuate a lot. For large companies, many costs are fixed or do not vary much with production. Companies could in principle lay off workers during a recession and rehire them during a boom so that costs rise and fall with income. But it’s not a great way to run a business. One consequence of an overall stable cost base is that as sales go up or down, profits go up and down much more. This “operating lever” is particularly powerful for companies in cyclical sectors, such as oil, mining and heavy industry. Indeed, changes in earnings forecasts are largely driven by cyclical stocks.
So global GDP growth falls, so profits will fall faster. There is already evidence of a slowdown. Readings of production and orders in the World Manufacturing Purchasing Managers Index (PMI), a closely watched activity marker, fell in June. Global retail sales surged in March, but have not changed since. The obvious slowdown in the Chinese economy may be an omen, writes Michael Hartnett of Bank of America. China emerged from containment earlier; his PMI peaked earlier; and its bond yields began to fall four months ahead of Treasury yields.
Slowing economic growth is part of a classic earnings squeeze. The other is rising costs. Various bottlenecks have pushed up the prices of key inputs, such as semiconductors. We are doing too much, says Robert Buckland of Citigroup, a bank. Input prices typically increase significantly in the early stages of a global recovery. Large listed companies usually absorb them without damaging profits too much. The rapid growth in sales outweighs the effect of the cost of inputs. The real factor in the swing is wages, which make up the bulk of business costs. The recovery is barely a year old, but there are already signs of a tight labor market.
In the United States, the ratio of job vacancies to new hires, a measure of how difficult it is for businesses to fill positions, hit a record high in May. Companies that were forced to close during the closures have lost workers to other industries. Others completely abandon the labor market. Thanks to the recent surge in asset prices, especially homes, some people are choosing to retire early, says Morgan Stanley’s Michael Wilson.
An obvious remedy for rising costs would be to increase prices. Although inflation is increasing in America, it reflects price increases for a small number of items. Many companies tend not to increase their prices immediately. They are aware of losing customers to competitors who do not raise prices. And there are administrative costs to frequently change prices. A 2008 study published by Emi Nakamura and Jon Steinsson, two academics, found that the median price duration is between eight and 11 months. Food and gas prices change monthly, but many services only change once a year.
A reduction in profits is not certain. A number of influences could give new impetus to globalization GDP growth: an exceptional infrastructure bill in America; more political revival in China; or some concrete signs that the bottlenecks are easing. Still, while the current earnings season is expected to be sunny, margins appear vulnerable.
This article appeared in the Finance & Economics section of the print edition under the title “Margin Call”