“The greatest difficulties lie where we are not looking for them!”
The above observation was penned by Johann Wolfgang von Goethe and may be very prescient in today’s economic and financial conditions.
Let us assume that the unthinkable happens: China’s economy slows down sharply, or even contracts – and there are reasons why it could. Commodity prices slump and bring about economic hardship in the resource-producing countries of the world. In turn, these countries’ imports of capital and consumer goods from Europe and Japan decline.
We would then have the perfect setting for a global economic contraction with dire consequences for corporate earnings and asset prices.
Now, I concede that this scenario is not very likely to occur. However, on a recent visit to Dubai, I could see how it might unfold. I have been travelling to the Middle East since 1977, and I experienced first-hand the oil boom of the late 1970s and the collapse in equity and real estate prices when oil prices fell in the early 1980s. About three years ago, on a visit to the Middle East, I felt that the gigantic
equity boom would come to an end.
In 2006, most of the Middle Eastern stock markets declined by 50% or more, though the economies didn’t suffer. Yet, over the last three years, it has seemed to me that there is something not quite right about the enormous construction and economic boom that Dubai and other Middle Eastern countries are experiencing. (The world’s tallest buildings are going up there….) What if oil prices were to decline? But why would oil prices decline? Obviously, oil prices would decline because of diminished demand for oil from China and other rapidly growing emerging economies.
But why would demand for oil from China slow down or decline? Obviously, because of an economic recession! The assumption that the Chinese and other emerging economies will continue to expand rapidly may prove to be very deceptive. In recent years, the US has experienced a credit boom and China has had a capital spending boom. Both could come to an end at about the same time! I also wish to stress that there is enormous connectivity between all the world’s economies and that it would be wrong to assume that the present financial crisis, whose epicentre is the United States, couldn’t be followed by financial and economic crises elsewhere.
Also, if the Dubai boom was an isolated event, I wouldn’t be particularly concerned. But everywhere I travel I am left with the uncomfortable feeling that the current boom is surreal and unsustainable. The INDABA – the annual conference for natural resources professionals – which I attended earlier this year in Cape Town, has become a huge circus reminiscent of the consumer electronic shows held in Las Vegas in the late 1990s.
And whereas I have a relatively positive view of commodities, I doubt that all these mining executives (predominantly promoters and liars) will make as much money as they hope to, simply because exploration and mining development costs are soaring. Every major city around the world is also experiencing a huge condo and office construction boom, and in resort areas there are enormous developments of secondary homes.
Should the financial sector contract, as I believe will occur for several years, will all these new offices find tenants? I also wonder if all the condo and second home buyers are aware of the maintenance costs of their units and that in over-supplied markets prices can decline sharply.
Lastly, I think that investors fail to appreciate fully the process of deleveraging after a period of accelerating credit growth. In a credit-driven economy, a deceleration of credit growth will depress all asset prices and tip the economy into recession. In this respect, I am particularly surprised that analysts still expect S&P 500 earnings per share to increase to above US$110 in 2009.
Over the past few months, I have discussed corporate profits a number of times and shared with my readers my concern that we are in the midst of an earnings bubble, which has been driven largely by an explosion of financial sector earnings.
Richard Berner, chief economist at Morgan Stanley, recently published an excellent study entitled “Downside Risk for Corporate Profits”, in
which he opines: “I think the earnings outlook will disappoint.
“The US economic outlook has darkened and fading operating leverage, dwindling pricing power, and deteriorating credit quality will squeeze margins. Despite the benefit of a weaker dollar, slower growth abroad seems likely to tame the overseas earnings boom” (Morgan Stanley Research North America, US Economics, March 17, 2008). In
Berner’s view, “the combination of slower growth and high operating and financial leverage in Corporate America made a contraction in earnings unavoidable even if the economy skirts recession”. (He is referring here to the corporate earnings decline in the fourth quarter of 2007.) “Lower marginal but higher fixed costs have increased operating leverage. Corporate America’s ability to exploit that leverage propelled earnings to record levels when growth was healthy. Strong increments to revenue went straight to the bottom line…. But leverage – both operating and financial – works both ways. Slower growth means that operating leverage is working in reverse, with decreases in revenues going right to the bottom line.”
Berner’s two principal concerns about US corporate profits relate to “operating leverage” and the fact that the “strength of overseas earnings” is about to be “challenged”. Operating leverage is at present far higher than in the 1990s, which, according to Berner, could mean that “a deeper recession, especially one that spreads abroad, would promote a much more serious profit squeeze.”
Berner shows that overseas earnings have increased from 15% of overall earnings 20 years ago to 31.5% at present, as “growth abroad – and the higher oil price that comes with it – are powerful engines for US earnings”. I may add that a weak dollar is another extremely powerful driver of overseas earnings as a percentage of total earnings. Also, that “growth abroad – and the higher oil price that comes with it – are powerful engines for US earnings” supports my view about the extreme connectivity we now have between economies in the global economy.
According to Berner:
“[T]here’s also a darker side to earnings from abroad. I worry about the potential for a vicious circle in transatlantic earnings. The US earnings downturn is already spilling over into weaker earnings abroad, especially in Europe. NIPA data show that US earnings remitted abroad in last year’s third quarter declined by 7% from Q3 2006. No doubt such weakness was a factor in our European strategy team’s recent earnings downgrade; they expect a 16% plunge in European earnings this year compared with the consensus forecast of a 7% increase. The impact of the US earnings downturn on Europe likely will be significant: US direct investment data suggest that about 2/3 of our payments abroad go to Europe.
“Such payments, which are earnings of US affiliates of foreign companies, crashed in the last recession – from a peak of $66 billion in Q1 2000 to a loss of $24 billion in Q4 2001. And for European companies the strength of the euro is a massive headwind: A 13% appreciation of the euro has magnified the earnings downturn in euros for European companies’ US affiliates [as it has magnified US overseas earnings – ed. note). Together with tighter financial conditions, I’m concerned that weak earnings at European companies could contribute to a sharp deceleration in capital spending and in European growth. That would complete the circle, because it would also hurt US earnings abroad. About half of those overseas earnings originate in Europe.”
I have pointed out above that there is now a much higher economic and financial connectivity in the world than has previously been the case. However, I have to confess that I hadn’t thought about, and fully appreciated, how weaker US growth, manifested as declining profits in the United States, would affect the affiliates of foreign companies, which in turn would lead to lower US overseas earnings. Richard Berner’s analysis is very perceptive! Also, I doubt that European stock markets have fully discounted the 16% plunge in 2008 European corporate earnings that Morgan Stanley has estimated!
Berner concludes his exposé of US corporate profits with the following – very politely phrased – remarks:
“Against this backdrop, what’s really perplexing is that Wall Street analysts don’t think that a weak 2008 will cast doubt on the vigor of next year’s results. On the contrary, in what I think is fundamentally flawed logic, they have maintained the level of their 2009 estimates where they were, so that downward revisions to 2008 earnings actually boost the 2009 growth rate. Street estimates for 2009 S&P 500 earnings growth have been revised up to 15.5% from 14.7% at the beginning of January. By comparison, we expect a 5.9% increase in 2009 after-tax economic profits that would leave the level below that in 2007.”
As an aside, a friend of mine, a very savvy and keen observer of economic and financial trends who doesn’t mince his words, calls what the Street has done with 2009 S&P earnings estimates “criminally insane”. I agree. After all, illusion is one of the most pervasive realities of life!
Markets and Money