If the economy is shaky, why are company profits still strong?

CONSUMERS are gloomy; the economy is shrinking; the Federal Reserve wants it to keep slowing and economists now say the whole world could be sliding toward recession.

At the same time, a lot of strong numbers are still coming out of many large American companies, which have been releasing their quarterly earnings reports and discussing their outlooks with Wall Street.

“We had an outstanding quarter,” American Express CEO Stephen Squeri said after the company reported record revenue.

“As our second-quarter results demonstrate, we have a lot to be proud of,” Hilton Worldwide CEO Christopher Nassetta said, noting that revenue per room in most major regions of the world was now above 2019 levels.

The blustery corporate optimism may seem at odds with the Fed’s grim determination to hold back the economy to get inflation down. But the economy is both what the Fed does and how companies and consumers are behaving. And the full picture of this strange economic moment is perhaps better captured by considering both sides together, central bankers and CEOs, no matter how divergent they seem.

Some big companies – Meta, for example – have reported disappointing numbers, and their CEOs are downbeat about the future. Other tech giants, Alphabet, Amazon, Apple and Microsoft included, all released results that, though hardly stellar, were enough to persuade investors that their businesses were not falling off a cliff.

Indeed, so far, with roughly half of all large companies having reported their numbers, this earnings season has not provided much evidence that the economy is entering a big crackup, and almost no CEOs talked about doing mass layoffs on earnings calls.

The lack of really bad news in earnings in part explains why the S&P 500 stock index has bounced about 12 per cent from its low point in June and why Wall Street analysts still predict that earnings for the companies in the S&P 500 will grow 10 per cent this year, according to data from FactSet. Although much of that growth is expected to come from energy companies, which have benefited from higher oil and gas prices, analysts expect profits to rise in 8 of the 11 industries represented in the index.

It’s an awfully rosy picture when “recession” is on people’s minds. That’s why for some on Wall Street, that optimism is absurd. Michael Burry, an investor who foresaw the 2008 mortgage meltdown, wrote on Twitter on Tuesday (Jul 26) that the earnings reports coming in felt like a “last hurrah’‘. Not done with fighting inflation, central banks are expected to continue pushing up the cost of borrowing, which would make corporate investments more expensive and dampen demand for companies’ products and services. Europe, a big market for US corporations, could have a nightmare winter if natural gas prices continue rising. And supply chains are still dysfunctional for many companies, meaning they can’t even make and sell products for which there is demand.

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“All those headwinds that created the downturn, they’re still intact and arguably getting worse,” said Mike O’Rourke, chief market strategist at JonesTrading.

Things could go into reverse quickly, the pessimists say. Many companies have for some time lived in a sort of nirvana in which they could keep hoisting their prices and customers would keep paying them, creating blowout profits.

Now there are signs that consumers are baulking at what companies charge, and if they pull back hard, their sales and earnings could take a big hit and lead CEOs to lay off workers and slash investments to protect profit margins and balance sheets. Early signs of this dynamic are emerging, according to some analysts.

Homebuilding companies, for instance, have been able to sell homes at ever-higher prices over the past 2 years, but as the Fed has raised interest rates, their senior executives say demand has fallen.

PulteGroup, a large homebuilder that reported earnings this past week, said the average price of its homes in the second quarter was US$531,000, a 19 per cent increase from a year earlier. The company forecast that the average would keep rising this year. At the same time, Pulte said, net new orders plunged 23 per cent from a year earlier, which the company blamed on the increase in mortgage rates.

“We’ll have to see how well the sector is able to hold on to those price increases that they’ve accumulated over the last couple of years,” said Brian Barnhurst, co-head of credit research for PGIM Fixed Income, a division of Prudential, referring to homebuilders.

Pulte did not respond to requests for comment.

Although well-off consumers show few signs of cutting back, the Q2 earnings contain plenty of evidence that some households are getting squeezed as inflation pushes up their bills.

AT&T said its customers were taking two days longer on average to pay their bills, which caused a hit to the phone company’s Q2 cash flow of almost US$1 billion. AT&T CEO John Stankey said on the earnings call that bad-debt levels were slightly higher than before the pandemic. But, he added, “We view this cycle no differently and still expect customers will pay their bills, albeit a little less timely.”

Big retailers such as Walmart have said their customers are spending so much on must-have items such as food and fuel that they’re eschewing higher-cost merchandise, including clothes and home goods. Since shoppers are still spending at Walmart for the staples, the company – and to a certain extent, the economy – still benefits from their purchases, although the shift has hit its profit margins and helped pummel its stock.

Banks earnings are a good place to get an early read on how consumers are faring. Overall, there are few signs at lenders that borrowers are having trouble repaying their loans, analysts say. “You would have come away from the quarterly earnings thinking that the consumer was generally in good shape,” said Moshe Orenbuch, an analyst who covers finance companies at Credit Suisse.

Because of pandemic stimulus payments, low unemployment and rising wages, the levels of past-due loans and bad debt fell to historical lows, but lenders have expected them to rise as borrowers reduce cash holdings and their balance sheets look more like they did before the pandemic. The finance industry has started calling that process “normalization”. It appears to have begun among lower-income borrowers.

Richard Fairbank, CEO of Capital One, a big credit-card lender, said on the company’s earnings call that this normalization was more evident in the bank’s subprime loans than in those made to borrowers with stronger credit. But Capital One declined to provide past-due loan numbers for its subprime loans, making it impossible to chart the extent of any deterioration.

The concern is that the heavy summer spending that has recently bolstered the earnings of the hospitality industries and the airlines is not sustainable. “There’s a faction of the market that’s quite convinced that when we get to the fall and the bills from the summer spending come home to roost, the consumer will be in a much trickier spot,” said PGIM’s Barnhurst. NYTIMES