How Long Will The “Earnings Recession” Last?

Ask any economist if the U.S. economy is in a recession, and they will say no. After all, the U.S. economy, as measured by gross domestic product (GDP), grew at a 1.5% clip in the third quarter.1

Even though that’s down sharply from the 2nd quarter’s 3.9% growth, it’s still holding above 0%. Based on that, the U.S. economy is technically not in a recession, but the stock market tells a different story. Stocks are on the verge of a recession—an earnings recession. What do I mean by that?

As of November 20, 2015, 96% of the companies in the S&P 500 have reported third-quarter results. Based on that data, research firm FactSet reports that S&P 500 companies’ earnings are set to drop 1.6% that quarter.2

That will be the second straight quarter of falling earnings, something that hasn’t happened since 2009. That’s why I said the U.S. stock market is on the verge of an “earnings recession.”

Energy Leads The Way
Weakness in the energy sector has played a key role in the earnings weakness. The price of crude oil fell 21.5% in the third quarter to $45.09. To put that into perspective, the average price of oil in last year’s third quarter was $97.10. Naturally, such a huge drop has negatively impacted the earnings of energy companies. According to the FactSet report, year-over-year earnings in the energy sector have declined by more than 60%.3

No wonder oil companies were the largest contributors to the annual decline in earnings for the S&P 500 Index. As you can see in the chart below (Figure #1), oil giant Exxon Mobil topped the list as the largest contributor to this aggregate decrease in earnings, accounting for 10% of the total decline. And, five other oil companies (Chevron, ConocoPhillips, Occidental Petroleum, Anadarko Petroleum and Schlumberger) also made the top-10 list.4

Fig. #1
Oil Companies Lead The Annual Earnings Decline For The S&P 500 Index

Source: EverBank Research Team, based on an analysis of publicly available data from FactSet.
(View a larger image here.) The impact of the energy sector has been so great that if you exclude it from the S&P 500 Index, the earnings growth rate for the index would jump from a decline of 1.6% to growth of 5.2%. Now, that doesn’t mean that a decline in oil is the only thing hurting earnings. The strength of the dollar has also been a major factor.

How The Strong U.S. Dollar Is Hurting EarningsTake a look at some of the comments made during third quarter earnings conference calls:

“Our third quarter comparable EPS was $0.51, which included a 12-point currency headwind.” Coca-Cola on October 21.

“So in the third quarter results, we have a pretty substantial headwind on the revenue line and quite a substantial EPS impact in currency in the third quarter. And in fact, when we look at the fourth quarter, there is still a significant impact in the fourth quarter in currency.” IBM on October 19.

Foreign exchange impacts reduced sales by 7.4 percentage points, with notable year-on-year declines in the euro, yen, and Brazilian real. These currencies devalued versus the U.S. dollar by 15%, 14%, and 37% respectively.” 3M on October 22.

Foreign exchange was a $1.2 billion drag on Industrial segment revenue and $165 million impact on Industrial segment operating profit.” General Electric on October 16.5

As you can see, the exchange rate has been a common theme this earnings season. This is especially true for big multinational companies that have significant exposure to international markets. For companies that do a large portion of their business overseas, a strong dollar leads to lower sales when the money is repatriated from a country with a weaker currency.

Look at companies that operate in Europe, for example. The recent weakness of the euro has negatively affected many companies that generate sales in Europe. According to research from FactSet, of the 11 companies in the Dow Jones Index that provided revenue growth numbers for Europe in their earnings conference call, all 11 mentioned some negative impact on revenues or earnings (or both) for third quarter.

The good news for stock investors is that most of the effect of the dollar’s appreciation since last summer may have already shown through to U.S. corporate profits. With the U.S. dollar stabilizing in recent weeks, the impact of the dollar on fourth quarter earnings could be less dramatic.

However, there’s always a chance the dollar could continue to appreciate. Especially now that we’re seeing more evidence the Fed could hike rates on December 16. That’s when the Fed will conclude its next two-day meeting and hold a press conference. It’s also important to note here that the Fed’s “unscheduled” meeting held Monday, November 23, didn’t yield any additional news on a rate hike.

Earlier this month, Fed Chairwoman Janet Yellen said, “At this point, I see the U.S. economy as performing well.” And, when asked about the interest rate hike, she said, “December would be a live possibility.”6

If the dollar continues to appreciate, we could see a further decline in earnings in the coming quarters. So, keep an eye on how the dollar will behave after December 16. If it continues to move higher, first quarter earnings may disappoint.

Until the next Daily Pfennig® edition…

Mike Meyer
Vice President
EverBank World Markets, a division of EverBank