LOM Weekly Perspectives

Economy rebounds but profits bounded

Data releases in the U.S. have continued to confirm a rebound in the economy. But after digesting all the good news the equity market still appears to be a little troubled. As always, it is looking ahead and is squinting to see how much profit there is on the horizon. By and large, the market has a glass-half-full attitude, but despite all the optimism, concerns about earnings growth that have been pushed into the background refuse to go away. If, as expected, economic growth in the second half of the year is likely to be less robust than in the first, then the sustainability of rapid earnings growth, as the year progresses, is also in doubt. Consensus analyst earnings-growth forecasts for the S&P 500, based on bottom-up analysis, are quite rosy. To realise this happy outcome, would require a more rapid rate of sales growth or heftier margin expansion than the current situation allows.

To get the top-line growing faster we need fairly robust consumer spending, as well as a sound pickup in capital expenditures. The latest readings on consumer sentiment are very encouraging but probably overstate the extent to which it will translate into more spending. Thus far, consumers have spent with gusto, sustaining growth but simultaneously shouldering quite a bit of debt expense, as a percentage of their disposable income. So they are a bit stretched and will react more or less carefully depending on the state of the job market, house prices and stock valuations – all of which have a measure of uncertainty attached to them. At the same time, as we have said before, there is not much in the way of pent-up demand in housing and autos to fire up spending in two of the largest categories. In addition, people will generally only open up their wallets if the price is right.

Last year, during the period of slow growth, firms were able to increase sales by offering attractive prices. Consumers have become accustomed to this practice and are, even now as better times return, willing to stare back until the sellers blink. The pricing arena is tough indeed, and will remain so. This is equally true for final and intermediate goods - both industrial and technological. Corporations, focused as they are on cost containment will bargain intensely to shave off any pennies that they can. And this puts suppliers firmly in the gun sight. Firms are willing to put the squeeze on suppliers, to the extent that business relationships are not thoroughly fouled up. They resorted to this practice, even in the years of plenty, but will continue to apply it more diligently in current circumstances. As a digression, for those investors rummaging for bargains among small-caps, make sure it isn’t one that can be held to ransom by big corporations.

Corporate pricing power was already constrained in the heady years of the late nineties, when markets were growing fast. Things are even tougher in the current environment of slower growth. Previously, excess spending on capital goods, as well as accounting shenanigans, helped to present a rosy but flawed picture of earnings growth. Executives are a little more sober now. Currently, capacity constraints aren’t very pressing, yet, and firms are careful about how much to spend on new equipment, hardware and software. Any spending needs to be justified by a solid business case.

So, if there is only going to be a modest increase in consumer spending, and export markets are also experiencing weak to moderate growth, then the expectation of a substantial pickup in business capital spending may meet with disappointment. In the current phase, productivity growth will result largely from more efficient use of existing capacity rather than substantial new capital investment. There is constant pressure to obtain maximum cost savings on all inputs. However, labour costs are not as downwardly flexible as many would like. This is particularly true of benefits costs. Meanwhile, oil and some basic material prices are rising. None of this portends well for margin expansion, despite productivity growth.