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Last Update: 20-Aug-12 09:52 ET
Global Economic Trends Aren't Pretty Picture
The world’s top four economies, accounting for approximately two-thirds of global economic activity, are either stagnant, decelerating, or in recession. There are no signs of an imminent turnaround. The same is true of the outlook for US earnings. The charts below clearly illustrate the problems.
The Top Four Economies
The world’s four largest economies in terms of US dollars are (a):
1. The United States with GDP of $15.1 trillion.
2. The 17-country eurozone with GDP of $13.1 trillion (b).
3. China with GDP of $7.3 trillion.
4. Japan with GDP of $5.9 trillion.
These economies are not doing well. In fact, a quick summary could be:
1. The US economy is struggling to maintain meager 2% real growth.
2. The eurozone economy is in recession.
3. Growth in China is decelerating significantly.
4. Japanese economic growth has been stagnant at 1% real growth for a decade.
The Pictures, Starting with the US and the Eurozone.
Below is a chart of US and eurozone year-over-year real GDP growth over the past three years.
After the recession of 2009, US real GDP growth temporarily jumped to its long-term trend of 3%. The past two years, US real growth has been grinding along near 2%.
Even this level of paltry growth is unlikely to continue. As discussed in the previous Big Picture titled, GDP Outlook Darkens, real growth in the second half of 2012 will drop to about a 1% annual rate.
The situation in the eurozone is even worse. Most press articles will state that the eurozone is not in recession. This may be true from a strict semantic standpoint, but that view amounts to mere sophistry.
The changes in eurozone real GDP the past three quarter have been -0.3% in the fourth quarter of 2011 (-1.2% annual rate per US methodology), 0.0% in the first quarter of this year, and -0.2% in the second quarter.
There are not two, straight negative quarters as required to officially declare a recession; but not a single quarter of growth over nine months and a net decline of 0.5% means that real GDP has certainly receded.
The current year-over-year change in the eurozone is -0.4% and it will get worse.
The recent eurozone economic declines have been mitigated by decent numbers out of Germany and France. Germany posted meager 0.3% growth (a 1.2% annual rate) in the second quarter, down from twice that rate of growth in the first quarter.
Growth in Germany has recently slowed, and there are indications from monthly data such as factory orders that it could go negative in the third quarter. France posted a 0.0% number in the second quarter, down from modest growth in the first quarter.
If growth in France and Germany slips at all in the third quarter, the eurozone GDP recession will get much worse.
China
Economic growth in China is slowing appreciably, as is evident in the chart below.
China experienced rapid economic growth following the global recession of 2008-2009, and real GDP growth reached 12% on a year-over-year basis.
Growth has since slowed dramatically to just 7.6% on a year-over-year basis for the second quarter. The trend is downward and a sharp slowdown in export growth in recent months suggests growth will decelerate further in the third quarter.
Japan
The underlying trends in Japan are obfuscated by fluctuations caused by the earthquake, tsunami, and nuclear incident of April 2011. The quarter-to-quarter changes are presented below.
Growth dipped sharply after the earthquake, and then rebounded significantly. Second quarter growth, however, was up only 0.3% from the first quarter. That is lousy growth that translated to a 1.3% annual rate.
But that is normal now for Japan. Real GDP in Japan over the past ten years has risen at only a 1% annual growth rate on average. Economic growth in Japan is back to its long-term sluggish trend.
Global Economies
In sum, there is virtually no good news on the global economic front.
U.S., China, and eurozone growth rates are likely to be lower in the second half of the year compared to the first. Japan will simply trudge along at 1% growth at best.
Implication for Earnings
Revenue growth for the S&P 500 in aggregate in the second quarter was a disappointing 3% compared to the second quarter of 2010.
Given that economic growth in all major regions of the world is likely to be lower in the second half of the year compared to the second quarter, revenue growth for the S&P 500 in aggregate is also likely to be lower.
Even if companies manage to hang on to 3% revenue growth, however, it is hard to presume that earnings growth will continue at any appreciable rate.
In fact, current forecasts are for a decline in third quarter earnings for the S&P 500 in aggregate of about 3%.
It is entirely possible that fourth quarter earnings also post a decline. Wall Street forecasts are currently at about 10% for that quarter, but that reflects the eternal optimism of Wall Street. If revenue growth is 3% or lower in the fourth quarter, there would need to be a large increase in profit margins for profits to rise 10%.
A large increase in profit margins from the current high historical rates is unlikely, particularly as higher commodity prices will hurt margins.
Instead, the decelerating trend in earnings growth of the past two and one-half years, as shown in the chart below, is likely to continue.
The downtrend towards slower earnings growth is clear.
The Cyclical Argument Debunked
There has been some talk that a decline in third quarter earnings would not be all that bad. After all, buying stocks when earnings are negative has often been a winning strategy historically.
Not this time.
The times when buying stocks on weak earnings worked were when earnings were at the low point of a V-shaped or U-shaped cycle.
Typically, the economy would weaken, as would earnings, and then corrective behavior would set in and an up cycle would commence. Buying stocks when earnings were weak anticipated the up cycle ahead.
Neither the US GDP chart nor the S&P earnings chart depicts a V-shaped or U-shaped cycle. There is no imminent upturn based on lower interest rates, the other side of an inventory cycle, or a reversal in temporary consumer behavior.
Instead, there is a clear, steady downtrend in earnings growth. Earnings growth rose sharply following the 2008-2009 recession as revenue recovered and businesses kept a lid on costs. Profit margins soared.
Over the past two years, however, revenue growth has been grinding lower. Profit margins have been topping out.
The chart and economic trends suggest it is more likely that profit growth continues to grind lower than that a sudden rebound in the fourth quarter occurs.
There is an argument for buying stocks based on valuation; but the argument for buying stocks because they often rebound following periods of negative earnings does not apply this cycle.
What It All Means
The global economic trends are worrisome. So are the trends in earnings.
Stock markets have been rallying in part because of the perception that credit market conditions in Europe have improved. That is, the risk of government defaults or a break-up of the euro appears less likely than at the start of the summer.
The reduction in risk associated with credit conditions is a legitimate positive factor for stocks.
It would be a huge mistake, however, to ignore the economic trends simply because of improved credit market conditions.
Draghi insisting that the European Central Bank (ECB) will defend the euro will not stimulate economic growth in Europe. The European economic outlook is poor regardless of whatever actions the ECB takes.
Neither the Fed nor the Chinese central bank is likely to do much to effectively stimulate growth either. Neither the first nor second round of quantitative easing pushed real GDP growth above 2%. The third is likely to be even less effective.
The stock market is going to have to deal with the reality of difficult global economic conditions and a poor earnings outlook for the foreseeable future.
--Dick Green
Founder and Chairman, Briefing.com
Footnotes:
(a) Based on IMF data, with Euro-zone adjustment based on Eurostat data.
(b) GDP for the 27-member European Union (EU) was $17.6 trillion and thus the largest in the world. The largest EU country not in the eurozone by far is the United Kingdom, accounting for 44% of the EU non-eurozone economy. Real GDP in the UK has declined in each of the past three quarters, and inclusion of the non-eurozone economies doesn’t improve the economic outlook at all. The other non-euro-zone EU countries are Sweden, Latvia, Lithuania, the Czech Republic, Poland, Romania, Bulgaria, Hungary, and Denmark.
The Top Four Economies
The world’s four largest economies in terms of US dollars are (a):
1. The United States with GDP of $15.1 trillion.
2. The 17-country eurozone with GDP of $13.1 trillion (b).
3. China with GDP of $7.3 trillion.
4. Japan with GDP of $5.9 trillion.
These economies are not doing well. In fact, a quick summary could be:
1. The US economy is struggling to maintain meager 2% real growth.
2. The eurozone economy is in recession.
3. Growth in China is decelerating significantly.
4. Japanese economic growth has been stagnant at 1% real growth for a decade.
The Pictures, Starting with the US and the Eurozone.
Below is a chart of US and eurozone year-over-year real GDP growth over the past three years.
After the recession of 2009, US real GDP growth temporarily jumped to its long-term trend of 3%. The past two years, US real growth has been grinding along near 2%.
Even this level of paltry growth is unlikely to continue. As discussed in the previous Big Picture titled, GDP Outlook Darkens, real growth in the second half of 2012 will drop to about a 1% annual rate.
The situation in the eurozone is even worse. Most press articles will state that the eurozone is not in recession. This may be true from a strict semantic standpoint, but that view amounts to mere sophistry.
The changes in eurozone real GDP the past three quarter have been -0.3% in the fourth quarter of 2011 (-1.2% annual rate per US methodology), 0.0% in the first quarter of this year, and -0.2% in the second quarter.
There are not two, straight negative quarters as required to officially declare a recession; but not a single quarter of growth over nine months and a net decline of 0.5% means that real GDP has certainly receded.
The current year-over-year change in the eurozone is -0.4% and it will get worse.
The recent eurozone economic declines have been mitigated by decent numbers out of Germany and France. Germany posted meager 0.3% growth (a 1.2% annual rate) in the second quarter, down from twice that rate of growth in the first quarter.
Growth in Germany has recently slowed, and there are indications from monthly data such as factory orders that it could go negative in the third quarter. France posted a 0.0% number in the second quarter, down from modest growth in the first quarter.
If growth in France and Germany slips at all in the third quarter, the eurozone GDP recession will get much worse.
China
Economic growth in China is slowing appreciably, as is evident in the chart below.
China experienced rapid economic growth following the global recession of 2008-2009, and real GDP growth reached 12% on a year-over-year basis.
Growth has since slowed dramatically to just 7.6% on a year-over-year basis for the second quarter. The trend is downward and a sharp slowdown in export growth in recent months suggests growth will decelerate further in the third quarter.
Japan
The underlying trends in Japan are obfuscated by fluctuations caused by the earthquake, tsunami, and nuclear incident of April 2011. The quarter-to-quarter changes are presented below.
Growth dipped sharply after the earthquake, and then rebounded significantly. Second quarter growth, however, was up only 0.3% from the first quarter. That is lousy growth that translated to a 1.3% annual rate.
But that is normal now for Japan. Real GDP in Japan over the past ten years has risen at only a 1% annual growth rate on average. Economic growth in Japan is back to its long-term sluggish trend.
Global Economies
In sum, there is virtually no good news on the global economic front.
U.S., China, and eurozone growth rates are likely to be lower in the second half of the year compared to the first. Japan will simply trudge along at 1% growth at best.
Implication for Earnings
Revenue growth for the S&P 500 in aggregate in the second quarter was a disappointing 3% compared to the second quarter of 2010.
Given that economic growth in all major regions of the world is likely to be lower in the second half of the year compared to the second quarter, revenue growth for the S&P 500 in aggregate is also likely to be lower.
Even if companies manage to hang on to 3% revenue growth, however, it is hard to presume that earnings growth will continue at any appreciable rate.
In fact, current forecasts are for a decline in third quarter earnings for the S&P 500 in aggregate of about 3%.
It is entirely possible that fourth quarter earnings also post a decline. Wall Street forecasts are currently at about 10% for that quarter, but that reflects the eternal optimism of Wall Street. If revenue growth is 3% or lower in the fourth quarter, there would need to be a large increase in profit margins for profits to rise 10%.
A large increase in profit margins from the current high historical rates is unlikely, particularly as higher commodity prices will hurt margins.
Instead, the decelerating trend in earnings growth of the past two and one-half years, as shown in the chart below, is likely to continue.
The downtrend towards slower earnings growth is clear.
The Cyclical Argument Debunked
There has been some talk that a decline in third quarter earnings would not be all that bad. After all, buying stocks when earnings are negative has often been a winning strategy historically.
Not this time.
The times when buying stocks on weak earnings worked were when earnings were at the low point of a V-shaped or U-shaped cycle.
Typically, the economy would weaken, as would earnings, and then corrective behavior would set in and an up cycle would commence. Buying stocks when earnings were weak anticipated the up cycle ahead.
Neither the US GDP chart nor the S&P earnings chart depicts a V-shaped or U-shaped cycle. There is no imminent upturn based on lower interest rates, the other side of an inventory cycle, or a reversal in temporary consumer behavior.
Instead, there is a clear, steady downtrend in earnings growth. Earnings growth rose sharply following the 2008-2009 recession as revenue recovered and businesses kept a lid on costs. Profit margins soared.
Over the past two years, however, revenue growth has been grinding lower. Profit margins have been topping out.
The chart and economic trends suggest it is more likely that profit growth continues to grind lower than that a sudden rebound in the fourth quarter occurs.
There is an argument for buying stocks based on valuation; but the argument for buying stocks because they often rebound following periods of negative earnings does not apply this cycle.
What It All Means
The global economic trends are worrisome. So are the trends in earnings.
Stock markets have been rallying in part because of the perception that credit market conditions in Europe have improved. That is, the risk of government defaults or a break-up of the euro appears less likely than at the start of the summer.
The reduction in risk associated with credit conditions is a legitimate positive factor for stocks.
It would be a huge mistake, however, to ignore the economic trends simply because of improved credit market conditions.
Draghi insisting that the European Central Bank (ECB) will defend the euro will not stimulate economic growth in Europe. The European economic outlook is poor regardless of whatever actions the ECB takes.
Neither the Fed nor the Chinese central bank is likely to do much to effectively stimulate growth either. Neither the first nor second round of quantitative easing pushed real GDP growth above 2%. The third is likely to be even less effective.
The stock market is going to have to deal with the reality of difficult global economic conditions and a poor earnings outlook for the foreseeable future.
--Dick Green
Founder and Chairman, Briefing.com
Footnotes:
(a) Based on IMF data, with Euro-zone adjustment based on Eurostat data.
(b) GDP for the 27-member European Union (EU) was $17.6 trillion and thus the largest in the world. The largest EU country not in the eurozone by far is the United Kingdom, accounting for 44% of the EU non-eurozone economy. Real GDP in the UK has declined in each of the past three quarters, and inclusion of the non-eurozone economies doesn’t improve the economic outlook at all. The other non-euro-zone EU countries are Sweden, Latvia, Lithuania, the Czech Republic, Poland, Romania, Bulgaria, Hungary, and Denmark.
