Earnings Are Heading into Even Rougher Seas

Profits of nonfinancial companies have proven impressively resilient, but the credit crunch, rising material costs, and cooling overseas demand will take their toll

It's earnings season and, as in the first quarter, downbeat results from financial companies for the second quarter are certain to dominate the news. Outside of finance, though, U.S. businesses have been coping surprisingly well, despite being caught between soaring materials costs and weak demand. Their strategy: cut labor costs, boost productivity, and lift prices where markets are still strong, especially overseas. Now comes the real challenge: The second half of 2008 is shaping up to be a lot less earnings-friendly for nonfinancial companies as well.

Contrary to expectations heading into 2008, the economy may end up weaker in the second half than it was in the first. Trouble at the mortgage giants Fannie Mae (FNM) and Freddie Mac (FRE) and the failure of IndyMac Bank imply the credit crunch is getting worse, not better—a bad sign for a housing recovery. Sky-high oil prices mean the drain on consumer demand will increase, not decrease. And growth overseas, a key to the recent buoyancy of growth and profits, is slowing.

Until now profits have been squeezed, but they have not plunged as they do in a recession. First-quarter earnings of the companies in Standard & Poor's (MHP) 500-stock index, outside of finance, rose about 7%, and analysts expect a similar showing in the second quarter. In the first half, resilient economic growth, combined with cuts in payrolls and pay, boosted productivity and restrained labor costs. Even in a weak U.S. pricing climate, margins have held up. Plus, exporters have been able to flex some pricing muscle amid strong overseas demand. June prices of U.S. exports were up 8.6% from a year ago, and strong currencies abroad are boosting the dollar value of earnings of U.S. foreign affiliates.

Making a buck in the second half will get a lot tougher. So far, the economy has been able to skirt an outright recession, with growth of 1% in the first quarter and expectations for 2% or better in the second quarter, but chances of a downturn appear to be on the rise again. A weaker economy would limit productivity gains, even as materials costs continue to rise.

More small business owners say higher costs are hammering profits, according to a June survey by the National Federation of Independent Business. For the first time since 1981, NFIB members say inflation is their top concern. Even excluding energy and food, wholesale prices for crude materials in June were up 33% from a year ago, while semi-finished intermediate goods, used to make final products, rose 8%. Both rates are triple those at this time last year.

Passing those costs on to consumer prices is already difficult and getting harder (chart). Ever-higher gas prices this summer will offset the income boost from the tax rebates. Overall consumer prices jumped 1.1% in June, swamping the month's 0.8% rise in nonauto retail sales. This fall, as the stimulus disappears, consumer spending could fall sharply, exerting a big drag on overall growth and further eroding pricing power.

At the same time, the new round of financial market upheaval will mean tighter credit conditions, especially in the mortgage market. Housing is the key to a broad economic recovery, but fixed mortgage rates are already more than a half-point higher than in April. That jump has pushed housing affordability back down to the levels of last fall just as housing demand has been showing clear signs of stabilizing.

Tighter credit and costlier energy are also eating into growth overseas. Manufacturing output in both the euro zone and Japan were declining in the second quarter, and growth in emerging markets, outside of China and India, has cooled. The big contribution to U.S. growth from foreign trade, estimated at 1 to 1.5 percentage points in the second quarter, will wane.

The problem for profits is that trade and consumer spending have been key sources of the economy's resilience. If analysts' current earnings expectations prove overly optimistic, investors may lose interest in more than just financial stocks.

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