Two leading investment banks declared last week that America has entered an earnings recession. Both Morgan Stanley and Merrill Lynch say that corporate profits have started to fall in America.
Earnings are dropping, however they are defined. Both profits as reported by companies and the numbers that appear in America’s national accounts were on a downward trend in the third quarter of the year.
Morgan Stanley’s strategy team estimates that earnings per share for the S&P 500 were down 2.8% in the third quarter compared with a year ago. The broader market performed better, according to official figures, with a rise of 2.7% over the same period, but there are signs of deterioration leading to weaker figures in future.
Richard Berner, the chief US economist at Morgan Stanley, says: “I think a squeeze on profit margins and slower volumes are doubly crushing earnings growth” (“The earnings recession”, Morgan Stanley Global Economic Forum, December 3, 2007).
He says the squeeze on profit margins is the key factor. Costs are rising, pricing power is dwindling and credit quality is deteriorating.
Another factor putting pressure on profit margins is leverage. When firms are growing strongly this can add to their forward momentum. But in periods of slow growth or outright contraction it works in reverse to squeeze margins further.
Although the overseas operations of American firms are generally performing well, their strength is unlikely to be enough to offset weakness at home. Berner says: “Even a solid contribution from growth in earnings abroad and the translation effect of a weaker dollar are unlikely to offset the effects of domestic margin compression.”
David Rosenberg, the North American economist at Merrill Lynch, takes a similar view. He estimates that corporate profits from domestic activity fell by 3.1% quarter-on-quarter in the third quarter. This was the third such drop in four quarters. The year-on-year trend is down 4.2% compared with a rise of 27% a year ago. Rosenberg (pictured) concludes that an economic “hard landing” has already arrived. (“Ten reasons why the consumer recession may be here”, Merrill Lynch, Morning Call Notes, December 3, 2007).