The media, and many of the econo-pundits they interview, are befuddled by the current profit picture. Why, they wonder, will Q1 profits decline materially while the economy continues to grow? They get that energy earnings have collapsed, but isn’t there an offset in lower energy costs for other companies, and more buying power for the consumer? One strategist told CNBC today that 2015 earnings estimates will rise because companies are low-balling their guidance to analysts, and the Street is not properly factoring in the coming benefit of low energy costs: “No one’s talking about lower input costs the second half of the year,” he says, “If you have lower natural gas prices and lower oil prices, that’s going to help the manufacturing sector.” The estimable Larry Kudlow has sung a similar song for the past few months, claiming low oil prices and a strong dollar are positive not negative, with non-energy segments of the S&P 500 benefiting a lot from low energy prices.
These gentlemen are on the wrong track because they do not fully grasp that S&P is not GDP. The profit recession is not an optical delusion caused by companies giving analysts “conservative guidance.” Low oil prices and a strong dollar really are hurting parts of corporate America, causing profits to decline. The brilliant Larry Fink (who was adamantly bullish on stocks a few years ago when most of the Street was cautious) is correct yet again when he warns the super-strong greenback is a significant headwind to U.S. growth because it will squeeze influential companies.
S&P Is Not GDP: Three Broad Principals . . .
S&P Earnings Are Nominal (include Inflation); GDP is Real (excludes inflation). So collapsing commodity prices hit S&P EPS hard but have little negative effect on—or can actually boost—real GDP, because the GDP deflator increases less than it would have if inflation were higher.
S&P Earnings are global, GDP is Domestic. The strong dollar has a much bigger negative impact on earnings than GDP. Exports are 13% of GDP and will eventually be squeezed by a strong dollar, but only with a long lag (as contracts expire). Around 40% of S&P profits are generated outside the U.S. by multinational firms. If IBM earns $2 billion in Europe, and the Euro falls 10% against the dollar, the value of those earnings when translated into dollars is 10% less.
S&P Earnings are much more geared to manufacturing, energy, and commodity production than the U.S. economy. Only 14% of GDP is mining and manufacturing; the rest is services, government, etc.. The easiest way to appreciate this is to walk around your hometown on a Saturday morning. All around you are businesses that are not in the S&P 500 – the construction company building a house across the street, a car dealership, the deli where you get your bagels, the landscapers putting in shrubs, the nail salon, beauty parlor, liquor store, restaurants etc. – not to mention government, which is 14% of GDP.
. . . and How They Apply to the Profit Picture Now
Let’s start with energy and the Exxon – Jane Doe transfer. Broadly speaking, collapsing energy prices shift national income from the corporate sector (Exxon) to the consumer (Jane); therefore it is negative for profits. A year ago the energy sector accounted for around 10% of S&P earnings, and since then oil prices have collapsed 50%, causing Q1 2015 energy earnings to decline 64% yr/yr. So that is a huge 6.4% hit to overall S&P earnings. There is an additional hit, mainly in the industrial sector, to all the suppliers to energy producers—steel piping from Nucor, helicopters from UTX, compressors from Caterpillar, project management services from Fluor.
But, you ask, what about the offsets? — The energy sector’s pain must be someone else’s gain, as consumers get a “tax cut” and spend more while non-energy S&P companies enjoy lower energy costs. Not so much. Yes, consumers get a “tax cut” but they may save the extra money, and if they do spend it they are likely to spend with a non-S&P 500 company—perhaps on a fancier dinner at a local restaurant.
The “lower energy cost” benefit to the profits of S&P 500 companies is also very modest, which is obvious if you think about it. Companies’ biggest cost by far—around two thirds of total cost—is labor; depreciation, rent, taxes, R&D etc. are also big. There are huge sectors of the S&P 500 where energy costs are trivial (think technology, finance, retailing, healthcare) and only a few where they are really big (airlines, trucking). And in some energy-intensive industries, such as chemicals, the potential cost benefit from lower energy costs is likely to be “competed away” instead of boosting profit margins.
The Impact of a Strong Dollar is More Mixed
We discussed the negative impact on S&P profits of translating earnings of foreign subsidiaries into fewer dollars when the dollar strengthens. But this is largely a cosmetic accounting effect rather than a reduction in underlying cash flows; most companies do not actually repatriate foreign earnings, which would involve paying high U.S. tax rates. That’s why $2 trillion of corporate cash languishes offshore.
To the extent the weak Euro is helping to revive the European economy by boosting net exports, this is a positive for all businesses in Europe, including subsidiaries of American companies. If Germany exports more Mercedes to China, that is positive for Mercedes suppliers in Germany, including U.S. firms like Borg Warner and Lear.
A Rebound in 2016(?)
Although the hit to 2015 earnings from a strong dollar and weak oil prices is real and won’t magically disappear in the second half, stock prices are not taking a big hit because investors believe, probably correctly, that the profit recession won’t continue next year. We could see a solid 8-15% rise in 2016 profits if the dollar does not keep soaring and if oil prices rise even modestly in 2016. But, let’s admit that the two key variables—the dollar and oil prices—are hard to forecast.
Flattish stock prices so far this year are consistent with my December 30 warning that equities were expensive and offered “mediocre risk reward.” As I recently discussed, and the WSJ later echoed, a potential Grexit could also start to weigh on equities. But amidst all the volatility the global economy continues to grow, with Europe performing better than I expected. Value is building in growth stocks, which will start to look fairly cheap on 2016 earnings.
Copyright Thomas Doerflinger 2015. All Rights Reserved.