Larry Kudlow (Bear Stearns economist, Reagan advisor and lately talking head) likes to say on his radio program that corporate profits are the mother’s milk of the stock market. This WSJ article begins with the ominous statement that the milk is running dry. The article quotes Ed Yardeni (who might be older than me) as saying that corporate profits will continue under pressure through the first half of 2016.
Via the WSJ:
The milk is running dry.
Corporate profits are contracting, and that’s a problem, for the stock market and the economy. It’s not quite as attention-grabbing as Black Friday, or even the monthly jobs report, but corporate profits are a key cog in the business cycle, and if they’ve fallen into an earnings recession, that’s a problem. So why aren’t more people worried?
Ostensibly, because two temporary trends are driving this: the weakness in the commodities sector, which is ravaging profits at energy companies, and the strong dollar, which is putting pressure on multinationals. There is a perception that the drop in corporate profits is somehow less real because of oil and the dollar, or more transitory than normal. Strip out those two, the argument goes, and everything looks fine. Moreover, people are betting that the collapse in oil prices has run its course, and the rise in the dollar is similarly over.
The problem with those dismissals is that oil may not be done going down, and the dollar may not be done going up. That could mean this “temporary” dip in profits will last longer than folks expect. “Weak commodity prices and a strong dollar are likely to continue to weigh on overall U.S. corporate profits through at least the first half of next year,” said Ed Yardeni of Yardeni Research. “The Fed may be about to start normalizing on expectations that the business cycle has turned more normal, but the profits cycle might not cooperate.”
The commodities market is definitely not cooperating. Indeed, the response to lower prices among producers hasn’t been to cut production. Some producers, Mr. Yardeni noted, have increased production, hoping to take advantage of the situation and drive out competitors. Some of them, he added, have no choice. “Many of them borrowed lots of money to expand capacity.” Now they have to keep producing in order to service the debt. This is something we noted in a story on Monday: mining companies continue to produce record amounts of copper, even as the price falls to new multiyear lows. OPEC is keeping production levels high, even with a specter of $20 oil.
The case against dollar strength is even more curious. The broad outlines of this are clear: In December, the Fed is almost certainly going to raise interest rates, which will see money come pouring into the dollar, and the ECB is almost certainly going to ease. The euro crossed under 1.06 against the dollar this morning, amid the most recent hints about what the ECB has planned. A year ago, it was at 1.25. “It’s fairly obvious that ECB President Mario Draghi is willing to do whatever it takes to drive the euro, which is currently at $1.06, down to $1.00 or lower,” Mr. Yardeni said.
Why does all this matter? Because profits are a key tell of where we are in the economic cycle. Two signs of a downturn are a narrowing of corporate margins, and contraction in corporate profits. Margins are peaking, and profits are dropping. In fact, revenue growth has been weak for years now, and so has profit growth. Companies have been compensating for weak sales with a variety of measures broadly called financial engineering that have obscured the top line’s impact on the bottom line.
Usually, this is about the time in an “average” cycle when the central bank starting thinking about lowering rates. But this most recent cycle is decidedly not average, which makes figuring out where everything is headed even trickier.