• Study shows profit growth usually suffers when the Fed acts
  • Analysts see S&P 500 profit falling three quarters in 2015.

Federal Reserve rate hikes haven’t been a bullish signal for U.S. corporate profits in the past. That’s bad news for investors banking on a rebound from the first quarterly retreat in earnings since 2009.

Since World War II, the median rate of growth in profits has decreased markedly when the Fed raised rates, falling by roughly half in the year after an increase, data from Ned Davis Research Group show. Income in the Standard & Poor’s 500 Index just contracted by 1.7 percent in the second quarter, breaking a streak of gains dating to 2009.

Any further slowdown in earnings is unlikely to sit well with investors who just endured the first 10 percent correction in four years. While analysts see profits rebounding in 2016 and 2017, the Ned Davis data suggest getting back to levels that underpinned a 192 percent advance in the S&P 500 since 2009 may be harder than they think.

“The market has been priced for perfection, and that even includes the effect of fairly optimistic assumptions for earnings growth,” said Brad McMillan, chief investment officer of Commonwealth Financial Network in Waltham, Massachusetts, which oversees $97 billion. “If the relationship about the Fed rate hike holds, then that disappointment could be much bigger than anyone is currently expecting.”

One of the reasons profits weakened after the Fed acted in the past is that rate hikes usually come after a period when they’re booming. Ned Davis found that the median pace of earnings expansion in corporate income was about 16 percent in the year before rate increases, compared with 7.6 percent normally.

Normalizing Policy

That’s not the case now. In the S&P 500, gains in quarterly profits have averaged 3 percent since the third quarter of 2014, down from 17 percent since the bull market began. Like elevated volatility and the unusual length of the bull market itself, the rate of earnings growth is another example of how the Fed is preparing to normalize policy at a time that is anything but normal.

“If you look at the timing of Fed increases, it typically comes after the peak of the rate of corporate profit, because they’re responding to the rate of growth,” said Wayne Wilbanks, who oversees about $2.5 billion as chief investment officer at Norfolk, Virginia-based Wilbanks, Smith & Thomas Asset Management LLC. “This time around, everything is growing slower. That’s why we’re predicting a lethargic stock market for the next three, four years.”

Profit expansions have slowed to a median 9.3 percent in the year after a tightening cycle starts, down from 15.7 percent in the period preceding one, data compiled by Ned Davis show. The deceleration is more pronounced in the two quarters on either side of the increase, when the rate of growth falls to 3 percent from 14 percent.

One reason earnings suffer is that higher borrowing costs are initiated to slow an overheating economy while costs for everything from labor to equipment are rising, according to Veneta Dimitrova, senior U.S. economist at Ned Davis in Venice, Florida. Rate hikes will underpin a stronger dollar, whose 15 percent ascent in the past year has hurt sales for multinational firms, she said.

Expectations Game

"The response of other economic factors could affect earnings if people change their behavior in anticipation of what the Fed is going to do,” Stephen Wood, who helps manage $265 billion as chief market strategist for North America at Russell Investments in New York, said by phone. “It’s all about the expectations of business owners, an expectations game that the Fed has to take into account."

Record-low interest rates pushed the cost of servicing debt for companies in the S&P 500 to an all-time low of 3.5 percent of sales in the past 12 months, according to data compiled by Bloomberg. The decline from 7.4 percent in 2007 represented $310 billion in savings and contributed to a doubling of profits and a three-fold increase in stock prices.

"If you’re taking a longer term approach, tailwinds companies experienced in terms of low borrowing and low labor costs may start to abate," Greg Woodard, a senior analyst and strategist at Fairport, New York-based Manning & Napier Inc., which oversees about $46 billion, said. "In coming years those could become headwinds."

History shows that once negative earnings quarters start to pile up, they keep going -- and the effect on investor sentiment is hard to arrest. Nine months tends to be the threshold: Among 17 declines that have lasted three quarters since the Great Depression, exactly one stopped there, in 1967.

Among S&P 500 members, combined quarterly profit growth has turned negative in 33 instances since 1937, data compiled by Bloomberg and S&P Dow Jones Indices show. While half of them lasted no more than six months, the others almost always dragged on, spanning five quarters on average. Out of the 17 occasions where earnings fell for at least three quarters, 14 occurred within three months of a bear market.

Analysts forecast profit will fall for another two quarters, sinking 6.2 percent during the current the period and 0.8 percent in the final three months of 2015, estimates compiled by Bloomberg show.

With companies already struggling to match last year’s levels of profitability, any harm from the Fed’s rate increase may make it harder for executives to wring up profit.

“Moving in that direction, it may slow down some of the buoyancy that we’re seeing in the consumer, some of the activity we’re seeing in housing and auto sales,” said David Joy, the Boston-based chief market strategist at Ameriprise Financial Inc., which oversees $815 billion. “I don’t think it’s going to be a make-or-break factor, but it would make a benign situation less benign.”

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