National Bank has a good report out this week that highlights some of the issues I have been expecting in my macro earnings outlook. Nothing has been more impressive than the margin expansion and subsequent profit fueled recovery of the last 18 months. Unfortunately, there are signs that this environment is beginning to normalize after several quarters of rising expectations and impressive expansion:
“With U.S. GDP expected to grow just slightly faster than potential in 2011, it will be very difficult for the U.S. and Canadian economies to generate double-digit profit growth next year. Profits are most likely nearing the end of the margin-expansion-fuelled upswing that has followed their unusually severe slump in 2008 and early 2009. The initial burst has now run its course and 2011 earnings growth is likely to be more conservative.
We expect 2011 GDP growth of 2.3% in the U.S. and 1.4% in Canada on a Q4/Q4 basis. Over the same period we expect operating earnings to grow 5% to 7% in the U.S. and 8% to 10% in Canada – significantly less than the analyst consensus of 15% for the S&P 500 and 22% for the S&P/TSX, but growth all the same.
One sign that the profits honeymoon of this economic cycle is fading is the trend of corporate earnings preannouncements. The ratio of negative to positive guidances had been very encouraging until recently. But after five consecutive quarters of relatively good news, the ratio is now back above the long-term average (chart).
The third quarter of 2010 may mark the beginning of a more normal environment, with pre-announcements closer to the long-term average ratio of 2.1. “
Margins have experienced an impressive expansion that has fueled the optimism in corporate earnings. Revenues have expanded marginally and allowed companies to halt their cost cutting campaigns, however, the growth has not become predictably sustainable as of yet. Analyst estimates have become increasingly optimistic based on these positive trends, however, as the macro economy begins to show some signs of weakness and revenues fail to expand margins are likely to stagnate. This ultimately means revenues must pick up the slack or companies will look to further cost cutting to keep their balance sheets lean. In an environment of very slow growth we’re likely to see more estimate cuts by corporations and/or analysts. If the economy slows more than expected we should expect to see further cost cuts and ultimately layoffs.