U.S. private-sector profit growth is slowing, and that has some investors worried about a recession. If it’s the deceleration that spells doom, readers can take heart: Many measures of corporate profits weren’t growing all that quickly to begin with.
A key gauge of U.S. corporate profitability—the S&P 500’s earnings per share—is set for its first decline since 2016. Specifically, according to S&P Capital IQ, third-quarter S&P 500 EPS is on track to slide 1.1% from the $36.76 in that period last year. Earnings rose 21% in all of 2018.
That matters because the stock market’s valuation is usually cited as a multiple of listed companies’ profit. So when earnings decline, stocks should fall in turn, unless investors have reason to be more optimistic about the future or decide to pay up for diminished growth.
There are problems with using the S&P 500 to determine the stage of the U.S. business cycle, however, because it captures only large multinational corporations. The index’s makeup also exaggerates the importance of the technology, finance, manufacturing, and energy sectors to the U.S. economy, according to the Bureau of Economic Analysis. Using an earnings per share figure creates problems as well, because it is affected by stock buybacks and changes in the value of pension-plan investments.
That means that the index’s EPS can swing sharply with overseas growth and global markets, without a comparable effect on the domestic economy. That happened in 2015, when S&P 500 earnings dropped by double-digit percentages. The decline was driven almost entirely by energy companies’ losses during that year’s slide in oil prices, according to FactSet data. The U.S. economy grew 2.9% that year.
Investors looking for a macroeconomic view of corporate profits should instead use the BEA’s National Income and Product Accounts, or NIPA. Those figures cover U.S. companies of all sizes, including private and pass-through corporations, using tax filings and other economic information.
As measured by the National Income and Product Accounts, profits have been growing slower than S&P 500 profits, no matter which way you cut the data. Before tax, NIPA profits climbed by just 3.4% in 2018. While after-tax growth was stronger, at 10%, much of that seems to be a result of changes to rules about deductions for asset depreciation in the 2017 Tax Cuts and Jobs Act.
Economists at Bernstein Research say that last year’s lackluster NIPA profit growth is a good thing.
“That growth was an artificial reality of tax cuts—organic growth was never particularly good; the slowdown in growth is just a return to reality,” Philipp Carlsson-Szlezak and Paul Swartz said in a recent note. “We still think [the growth deceleration] tells an interesting story of stability and a positive narrative of why corporate profit growth is now facing headwinds.”
They argue that corporate profits are declining primarily because workers are earning higher wages and taking a greater share of U.S. economic output. They say that the American worker and consumer can drive growth, even if their employers’ margins are sliding.
The profit picture isn’t expected to improve much from here.
Wall Street analysts expect another decline this quarter, and almost no growth for the full year. So UBS is telling clients to prepare for an “earnings recession” and a corresponding decline in the stock market. And Morgan Stanley’s wealth-management division warns that “stock prices [are] outrunning earnings.”
On the other hand, readings of U.S. economic output show that a full-blown recession hasn’t hit. And if the economy survived mediocre earnings growth last year, it should be able to keep muddling along without it this year.
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