More on the global economic slowdown and the drop in corporate earnings

I want to tie a few threads together regarding the synchronised global slowdown and the related drop in corporate earnings. US firms had been insulated on earnings due to not increasing staff and the global nature of their profiles. With economies now slowing globally and the US dollar rising, that spells bad things for earnings. I can’t see stocks performing well in a recession with that backdrop.

The first thing to note, however, is that a drop in earnings does not necessarily imply a drop in share prices, although it should. For example, late last month, US corporate earnings were reported to have actually shrunk in Q1 2012.

Profits from current production (corporate profits with inventory valuation and capital consumption adjustments) decreased $6.4 billion in the first quarter, in contrast to an increase of $16.8 billion in the fourth quarter.  Current-production cash flow (net cash flow with inventory valuation adjustment) — the internal funds available to corporations for investment — decreased $123.9 billion in the first quarter, in contrast to an increase of $44.8 billion in the fourth.

Not many people realise that US company earnings are now shrinking. And yet since that announcement, stocks are up with S&P moving from 1330 to 1360.

Let’s remember that in the tech sector for example that Microsoft reported a massive writedown, Cisco reduced head count, and Nokia and RIM reported massive losses, while Apple missed earnings and revenue estimates. These are all growth companies except Microsoft. But still, the market is up.

Real economy data is weak. Here’s one indicator I think is innovative: Waste carloads are way down. According to economists Michael McDonough and Carl Riccadonna waste has an 82 percent correlation to US economic growth. And waste tonnage is way down. So, it should make sense that profits are down in that environment but then there is the European connection here as well. The Wall Street Journal reports that:

Europe’s deepening economic crisis is cutting into corporate earnings, with the continent’s woes threatening to exert a drag on multinational corporations around the world into next year.

This week, U.S. companies ranging from Ford Motor Co. to Apple Inc have blamed disappointing results on slowed spending by European consumers. Meanwhile European heavyweights including steelmaker ArcelorMittal and pharmaceutical company GlaxoSmithKline PLC said they are suffering more than expected on their home turf.

In a sign of how bad companies think it could get, hard-hit Spanish communications company Telefónica SA said Wednesday it is suspending dividend payments and share buybacks for the rest of the year, after reporting a 14% drop in quarterly profit.

"I don’t see the light at the end of the tunnel," said Leif Östling, chief executive of Swedish truck maker Scania AB, which reported a 40% decline in profit Wednesday.

The corporate alarm bells highlight how the miserable economic conditions in much of Europe are spilling onto the global stage. With much of Europe in recession and unemployment soaring, spending is sliding on everything from big-ticket items like cars to everyday staples like yogurt.

The point, of course, is that this is a global slowdown and there’s nowhere to hide. I expect earnings to continue to erode. The question is whether this feeds through to share prices. My macro view here is that recession is coming and Fed attempts at asset inflation will be overwhelmed by real economy deflation in a New York minute. The Fed would have to go in here guns blazing for this not to be the case i.e. buying muni bonds, MBS and all manner of private sector financial assets it can buy without specific congressional approval. Will that happen before market carnage can begin? Will it happen at all? I don’t see the case for the Fed being aggressive early.

The Fed may extend permanent zero out to 2015. They may even go QE in small measure. It won’t be guns blazing. If there’s no QE, the markets will not be happy.

Update, the following from John Hussman is useful in this context:

The key question – in view of extreme credit market strains in Europe, and accelerating economic deterioration in the U.S. – is why the S&P 500 continues to trade within a few percent of its April bull market high. The answer is simple: investors are scared to death of missing the widely anticipated market advance that they expect to follow a widely anticipated third round of quantitative easing. Good economic news may be a relief for investors, but bad economic news in this context is just as much of a relief because it brings forward the anticipated delivery date of the sugar. The follow-up question, however, is that if more QE is widely anticipated, and a market advance is widely anticipated to result, isn’t that the precise definition of an event that is already priced into the market?