As Economy Slows, Earnings Slowdown Looms

Start talking about a soft landing for the economy and you can just about see investors' shoulders loosening up.

The past month's deepest worries have been based on the notion that the U.S. is reeling toward recession, what with rising oil prices, higher interest rates and widening credit spreads. But the economy has been growing at such a fast clip -- at the last reading, gross domestic product was rising at a 6.1% rate -- that it has a big cushion. Meanwhile, core inflation remains remarkably tame -- despite the run in energy prices and low unemployment rate -- and productivity gains continue to surprise. The economy may slow -- the forecast has settled in around 3% growth in 2001 -- but that's a long way away from a serious economic downturn.

This may not be cause for celebration, however. Even slight changes in overall economic growth have an outsize effect on corporate America's bottom line. On the way up, this is a fine thing: It's the reason corporate profits gained in excess of 10% in the last few quarters even though GDP was growing, on an annual basis, around 5%. But with economic growth slowing, it's possible that profits, because of this same operating leverage, could turn negative at some point next year even if the economy doesn't.

Leverage This

Operating leverage exists because businesses have two kinds of costs -- ones that move up and down with demand, and those that are fixed. If you run a match factory, for example, you've got a lot of costs that depend on how many matchbooks you sell, like paper, sulfur, something called celite. But you also have costs that occur no matter what, like keeping the lights on, paying salaried workers, making sure the ventilation system and fire extinguishers are well-maintained. When demand increases, those fixed costs represent a smaller portion of total sales, and more of your top line makes it to the bottom line. Profit margins expand. But when demand slows, you still have to pay those costs. Margins contract.

"We have earnings growth going down below 5%" in 2001, says Morgan Stanley Dean Witter economist David Greenlaw. But Greenlaw worries what would happen if the economy grew by less than the 3.4% that his firm is forecasting. "If you slip much below there," he says, "it wouldn't take much to get corporate profits into negative territory."

This is something like what happened in the late '80s: On the back of a series of rate hikes, economic growth slowed to a little better than 2%, but U.S. corporate profits declined by as much as 10%.

U.S. profits did not, however, go negative when the economy soft-landed in the mid-90s -- in fact, they showed double-digit growth. And when profits did dip into the red in 1998, the economy was steaming. Greenlaw reckons this breakdown is a result of a global economy that was not running alongside the U.S. In 1998, for example, while things were fine here, much of the world was getting crushed under the heel of crisis. Now that the U.S. and the rest of the world appear to be moving more or less in sync, the link between GDP and earnings should reassert itself.

Cyclical vs. Noncyclical

Even if that's true, it doesn't mean the stock market will necessarily be damaged. There is a difference, says Lehman Brothers chief investment strategist Jeff Applegate, between U.S. corporate profits and the profits of the companies in the benchmark S&P 500, because investors have been rewarding the companies best able to grow regardless of what the economy is doing.

"You don't have a normal cyclical relationship between final demand and margins," says Applegate. "Even in the event of a slowdown, earnings won't slow down that much."

Applegate believes a big reason S&P 500 earnings won't be affected by an economic slowdown is that many S&P companies are more tech-related now than in the past. And Applegate reckons that tech companies' earnings -- excluding sectors like semiconductors -- are noncyclical.

This is a matter of contention. One of the big reasons tech stocks have run into so much trouble lately is a growing belief that tech earnings are much more cyclical than people had reckoned. There are some who believe that the worst earnings news has yet to come.

"We're actually anticipating that in the first quarter of 2001, earnings will be flat" in comparison with year-ago levels, says Banc of America Securities equity portfolio strategist Tom McManus. "That's a lot more severe an earnings downturn than is currently built into the market."