U.S.: Investors May Be Missing the Brighter Side of Profits
There was a time last year when bad news on the economy sent stock prices soaring in anticipation that the Federal Reserve would cut interest rates. Not anymore. Equity investors are focused squarely on profits, and they are using data on the economy as a proxy for the earnings outlook. The most recent example: Stock prices dove on Aug. 28 on news of only a small decline in consumer confidence.
To be sure, recent profit reports have made for grim reading. According to the Commerce Dept.'s Aug. 29 revisions to second-quarter gross domestic product, which included economywide data on last quarter's profits, operating earnings dropped 3.6% from the first quarter. And profit margins sank to an 8-year low (chart). The revised GDP data show that the economy rose at a mere 0.2% annual rate last quarter--even with a more rapid rate of inventory liquidation than previously reported. Still, the weakness added support to analysts who argue that continued poor revenues mean that the profits recession has longer to run.
But investors may be overlooking the cost side of the profits outlook. It's looking rosier, because some major expenses for Corporate America are not going to be increasing as they have in recent quarters. Already, energy costs are falling, labor costs are rising more slowly, and lower interest rates mean new borrowing and servicing old debt are cheaper. Add in the benefits of a declining dollar and a pickup in productivity growth, and these trends imply that even if real GDP grows modestly, profits outside of tech could post some positive surprises early next year.
THE GREATEST SAVING is likely to come from labor costs, businesses' biggest expense. But the savings here may not necessarily come from layoffs. True, pink slips are a quick, though brutal, way to cut costs. But thanks to lower inflation and increased job jitters among workers, employers will not have to raise pay as much or offer as many benefits to placate their workforces in coming quarters.
Labor-cost growth is already slowing. In 2000, hourly compensation rose 7.5%. But in the first half of 2001, growth stood at a 4.8% annual rate. If labor costs rise by 5% over the next year instead of 7.5%, businesses will spend $150 billion less on compensation.
Also, cheaper energy will have a huge impact. Although gasoline prices at the retail level are edging up, producer costs for energy have been plummeting. In June and July, the producer price index for finished energy goods fell a combined 8.1%, the biggest two-month drop since the end of the gulf war. The PPI shows that energy prices in July were back to where they were in July, 2000.
Lastly, borrowing costs are falling. In the second quarter, net interest paid by nonfinancial corporations fell 3.7% from a year ago. Part of the decline reflects a drop in loan demand, but the Fed's rate cuts have reduced the cost of borrowing, especially for small businesses that rely on bank lending.
Two other factors that could lift the bottom line in early 2002 are improved productivity and the recent weakening of the dollar. Typically, when an economy comes out of a slowdown, productivity picks up because businesses work their existing employees harder before adding workers. With U.S. companies holding an overhang of capital equipment, that trend should be especially evident into early 2002. In fact, hiring is unlikely to turn around until GDP growth is near 3%. The productivity boost should hold down unit labor costs, which means fatter margins.
The weaker dollar will help profits when companies convert overseas earnings into dollars. Its trade-weighted value has fallen 3.7% since early July, and a further decline from its exceptionally high level is likely. Unfortunately, the cheaper dollar will have little impact on boosting exports, since the global slowdown is holding down demand for U.S. products.
INDEED, REVENUES--both abroad and at home--remain the biggest risk in the profits outlook. On that score, the latest data are mixed. Although confidence has come down from its heady readings of 2000, it remains at a historically high level (chart). And July and early August data suggest that consumers are upbeat enough to keep spending at a modest pace. But falling new orders for capital goods mean that business demand and sentiment about the future are still sinking.
In August, the Conference Board's index of consumer confidence slipped to 114.3 from 116.3 in July. The board said that job jitters caused a drop in households' assessment of current economic conditions. But expectations about the economy's performance six months from now rose in August, and they have been on a rising trend since February. Household spending correlates better with consumers' expectations than with their feelings about their current situation.
The optimism is also evident in consumers' willingness to buying big-ticket items like a house. New home sales rose 4.9% in August. And although existing home sales dropped 3% during the same month, they are on track to post their second-best year ever, just below 1999's record high of 5.2 million.
THE NEWS IS MUCH LESS BLISSFUL on the business side, however. New orders for capital goods, considered a proxy for business optimism, fell 1.9% in August, the fourth decline in a row. The drop is a sign that companies, unlike consumers, are too pessimistic to commit to investing in big-ticket capital goods.
This contrast between consumers and businesses was echoed in the revisions to second-quarter GDP. Consumer spending grew 2.5%, not much different from the preliminary data. But business investment on equipment fell 15.1%, and companies liquidated their inventories by $38.4 billion, $11.5 billion more than first reported. Provided that consumer demand continues to grow moderately, the sharp inventory correction outside of the tech sector is laying the groundwork for a small pickup in ordering and output.
However, weak demand for tech equipment and excessive tech inventories will continue to skew the top-line data. It may take until early next year before the tech part of the inventory problem is brought under control (chart). Part of that drawdown will come from tech companies slashing prices. That's why the tech sector is one area where the profit outlook remains dim.
But one company's fire sale is another's bargain. Nontech companies will be able to save money on high-tech equipment. And those savings are yet another gain for profits.
To be sure, the profit outlook still carries many dangers. Paramount among those is a surprise pullback by consumers, which could send the expansion into a tailspin. But companies seem to have a good handle on costs going forward. And that should be welcome news both for the economy and Wall Street.
By James C. Cooper & Kathleen Madigan