- Second-quarter earnings for the S&P 500 are expected to rise 27% from a year ago.
- Unit labor costs have plunged by a record 5.5% over the past five quarters.
- Nonfinancial corporations hold $1.8 trillion in cash and other liquid assets.
As the second quarter draws to a close, corporate earnings reports may provide some welcome relief to weary stock investors. Markets will likely shift their attention away from Europe’s sovereign debt crisis and back to the exceptional financial health of corporate America and its implications for the economic recovery.
Wall Street analysts expect this quarter’s earnings per share for companies in the Standard & Poor’s 500 stock index to advance 27 percent from a year ago, based on canvassing by Thomson Reuters. The materials, energy and IT sectors are expected to record the strongest showings. That would follow the blowout first quarter, when earnings per share rose 57 percent.
A strong upsurge in profits has been a good omen for economic growth in the early stages of past recoveries. Based on the much broader tally of corporate profits pulled together by the Commerce Department, profits in the first quarter were up 31 percent from a year ago. That growth rate has been seen only six other times in the past 60 years. “In each of these periods, real GDP and employment have grown solidly over the next year,” says Barclays Capital economist Dean Maki. Job growth, which is essential to a self-sustaining recovery, has never failed to grow less than 1.9 percent during these times. That would translate into 2.5 million jobs in 2010 and accelerating monthly gains in coming months.
The earnings rebound from the depths of the recession early last year is broadening. In recent quarters, the strong revival in the beaten down finance sector skewed overall performance, but now earnings among nonfinancial corporations are speeding up, as well.
After falling for more than two years, those profits rose 12 percent in the fourth quarter of last year and soared 26 percent in this year’s first quarter. Domestic profits, which are important for the expansion of U.S.-based operations, have shown remarkable strength, rising 40 percent in the first quarter.
Reasons for the earnings boom — and why profit growth should remain healthy — aren’t hard to find. Look at the exceptionally deep cuts in costs and debt levels that corporations made during the recession, many of which were far out of proportion to the loss in economic output. While the economy shrank 3.7 percent, slightly greater than the drop of about 3 percent during each of the previous severe recessions in the early 1970s and 1980s, companies slashed payrolls by 6.1 percent — twice as much as during those earlier downturns.
The result has been a record 5.5 percent drop in unit labor costs, or wages and benefits divided by output.
Although companies have little ability to raise prices, the drop in unit labor costs has increased their profit margins, or what they earn on each item they sell. In fact, profit margins at nonfinancial corporations through the first quarter are substantially higher than at this stage of the recovery from the 2001 recession. With demand now picking up, higher margins mean that more of top-line sales growth is falling to the bottom line.
In addition, businesses cut back spending on new equipment by so much that last year that machinery, computers, and other business equipment were wearing out faster than they were being replaced. That has never happened, at least not since the 1930s. Companies also unloaded a disproportionate amount of inventory. Morgan Stanley economist Richard Berner calculates that stocks of manufacturers, wholesalers and retailers plummeted 7.4 percent, some as much as 50 percent, more than the declines seen in the brutal 1981-82 recession.
This cost-cutting has left companies historically short of workers and equipment in an economy growing 3 percent to 4 percent. They have the need, ability and incentive to start expanding their payrolls, capital spending, and inventories.
Meanwhile, companies are sitting on a mountain of idle cash earning close to 0 percent. That’s certainly not what stockholders, looking for a return on their investments, would like to see. In the first quarter, nonfinancial corporations had piled up a record $1.8 trillion in cash and other liquid assets, according the latest data from the Federal Reserve. That represented 7 percent of all corporate assets, the highest percentage in nearly 50 years.
Companies have been cautious about putting that cash to work toward new hiring and capital investment partly because of uncertainties over reforms in health care, financial regulation, executive compensation, and most recently, the turmoil in Europe. For the past year, nonfinancial corporations have had more than enough cash flow, or profits minus taxes and dividends, to cover all their capital expenditures. That’s rare by historical standards, but it also means that companies are in a position to step up their outlays without the need for significant additional borrowing.
If current expectations are on the mark, the second-quarter earnings season will be one more marker ofthe improving prospects for a sustainable recovery. Those company reports should also be good news for investors. Regardless of uncertainties overseas, it’s always earnings here at home that drive stock prices.
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