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Profits are down in America Inc

“IT’S NOT that bad,” remarked Jamie Dimon, boss of JP Morgan Chase, of the global economy on July 16th. But, Wall Street’s favourite banker had to concede, business sentiment “is a little bit worse”. Prospects for American companies have indeed dimmed. Analysts expect earnings of the biggest among them, which have just begun reporting their latest set of results, to have declined in the second quarter. This would mark two consecutive quarters of falling profits, the first such “earnings recession” since 2016. Coming just as the current economic expansion makes history as America’s longest ever, it raises the prospect of a long boom running out of steam. Bosses are getting twitchy.

America Inc has enjoyed an extraordinarily good run since the country rebounded from the global financial crisis of 2008-09. The economy has grown, inflation has been low and interest rates rock-bottom. Despite unemployment hovering below 5% wage pressures have been modest. All told, annualised corporate profits exceeded $2trn last quarter, nearly double the level a decade ago. President Donald Trump’s tax reform cut the corporate tax rate from 35% to 21%. This and his deregulatory efforts have freed up capital. Companies have used the windfall to buy back shares—reducing the amount of stock and superficially boosting earnings per share. The S&P 500, Dow Jones Industrial Average and Nasdaq Composite, three leading share indices, hit record highs on July 15th.

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Today the mood in boardrooms is less ebullient. The latest survey by the Business Roundtable, a conclave of bosses (chaired by Mr Dimon), put confidence higher than the historical average and well above the level which would signal a recession. But it has slipped. The National Federation of Independent Business observes a similar decline in optimism among bosses of small and medium-size enterprises. Nearly four-fifths of S&P 500 firms that have issued guidance on financial performance for the latest quarter have indicated that earnings per share will fall year on year.

Analysts’ forecasts reflect these sentiments. Profits in six out of eleven big industries may have declined from April to June compared with a year earlier (see chart). FactSet, a research firm, estimates an average drop of 2.8% for S&P 500 earnings, on top of a 0.3% dip the quarter before. Observers—and executives themselves—see three reasons for the darkening outlook.

The most prominent is Mr Trump’s trade war with China. Doug McMillon, boss of Walmart, has warned that tariffs will lead to higher costs for the retail giant, which sells plenty of Chinese-made goods. David Herring, head of the National Pork Producers Council, this week told Congress that the lobby group’s members were suffering from Chinese retaliatory tariffs on American pork. Despite his friendly encounter with China’s president, Xi Jinping, at a G20 summit in late June, Mr Trump threatened this week to impose fresh tariffs on $325bn of Chinese imports. According to JP Morgan Chase, the new levies could tip the economy into a contraction.

A survey of companies by the Institute for Supply Management (ISM) echoes such worries. A manager at a chemicals firm told ISM that the levies were increasing costs. Another at a metals company worried they would weaken global demand for its products. Trade frictions are “wreaking havoc with supply chains and costs”, according to an executive at electronics manufacturer. “The situation is crazy.”

The second reason for falling profits—rising labour costs—is good for workers but worrying for firms and investors. Amazon raised wages to $15 an hour in late 2018, as the labour market tightened. Costco and other retailers are doing the same. If pork tariffs weren’t enough, Mr Herring also reckons that farms and packing plants may shut down for lack of workers. Michael McDonald, president of the Sewn Products Equipment & Suppliers of the Americas, a trade group, says that clothesmakers face a “sizeable labour shortage”.

David Kostin of Goldman Sachs, an investment bank, calculates that total compensation, which includes wages and all benefits, represents 13% of sales for a typical American firm. Wages and benefits are now rising at roughly 3% a year, up from 2% in 2018 and just 1% earlier in the business cycle. Michael Wilson of Morgan Stanley, another investment bank, reckons the official figures conceal much higher rises in such industries as retail, hotels and commercial services.

The final explanation for the earnings crunch has to do with technology companies. Patrick Palfrey of Credit Suisse, one more investment bank, notes that the list of top ten contributors to the second quarter’s profit crunch includes representatives of Big Tech. Hardware and semiconductor goliaths such as Apple and Intel are facing a cyclical downturn in demand for their products. Trade spats exacerbate it. So too has Mr Trump’s decision on national-security grounds to impose sanctions on Huawei, China’s tech champion, which has upended global supply chains. Some internet firms are sputtering. Netflix’s share price lost 12% in after-hours trading on July 17th, when the streaming giant reported the first drop in American subscribers since 2011.

Big trouble at a few massive—and massively profitable—tech firms may be dragging down average earnings. As Mr Kostin points out, some tech titans may see profits squeezed by 10% whereas the median technology firm can expect a rise in earnings per share of perhaps 3%. Some big firms, like Microsoft and Amazon, continue to thrive. Similarly, the aggregate decline in second-quarter earnings hides the fact that the median American company should see profit growth of 4%.

The good times, on this view, are not quite over. “The headwinds will abate by 2020,” predicts Mr Palfrey. Many American bosses agree. Unless the Sino-American tariff tiffs turn into a full-blown trade war, they think, companies can handle the challenges. The Federal Reserve has recently turned dovish, partly in response to Mr Trump’s hawkishness on trade. It may cut interest rates, which could extend the economic expansion further.

Not everyone accepts this view. Morgan Stanley expects profits across the metals and mining industries to decline, for example. The bank is also bearish on tech, where the “breadth of the expected negative results is stunning”. Mr Wilson, who was among the first to foresee the current decline in profits, believes that earnings have not yet hit the bottom. “The picture is getting worse, not better,” he warns.

Unless America’s expansion enters Australia’s territory of 20-plus years of continuous GDP growth, the boost to profits from Mr Trump’s tax cuts came nearer the end than the beginning. That may have created excesses. As a share of GDP, corporate debt is nearly where it was before the subprime bubble burst in 2008. Inventories are building up across the economy. Firms must absorb higher depreciation costs from a tax-fuelled splurge of capital spending. All this can weigh on profitability.

The quarterly financial results unveiled this week by several big banks bolster the case for cautious optimism. A boom in credit cards and mortgages pushed profits up at JPMorgan Chase, Citigroup and Wells Fargo. This implies that, as Mr Dimon also said this week, “the consumer in the United States is doing fine.” This will be cold comfort to industrial firms and other business-facing companies whose margins are shrinking. Given the sheer length of America’s record economic expansion, however, it really is not that bad.■

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