The U.S. economy is slowing, earnings growth is increasingly scarce and the negative effects of a 100 basis point rise in interest rates are only beginning to filter through. And this is before we see data reflecting the economic drag of the ongoing government shutdown.
Factset's discovery of a record number of U.S. companies guiding profits lower presaged a very weak third-quarter earnings season for the S&P 500. So far, although the number of companies reporting is small at 37, Reuters reports that more than 30 per cent have posted profit growth below analyst expectations.
The Citi Economic Surprise Index (U.S.) , which measures economic data reports relative to expectations, also continues to slide (on limited data given the shutdown) in a sign that economists will shortly begin cutting their forecasts for the fourth quarter and calendar 2013.
The past few years have seen strong U.S. corporate earnings growth despite sluggish economic activity, but recent indications suggest this trend may be ending. The trailing 12-month earnings per share for the S&P 500 has declined from $104.83 (U.S.) to $103.90 since April. While that doesn't look like a big move, it's the biggest decline since mid-2011.
The 10-year U.S. Treasury yield stands 1.1 per cent higher since the first hints of Fed tapering in May. Higher bond yields have already translated into rising mortgage rates, which have stalled U.S. housing demand. The Mortgage Bankers Association Basic Index, which tracks mortgage applications, has declined 52 per cent in the past five months.
The interest rate spike will also create issues for corporate profits. The artificially low rates arranged by the Fed gave companies a chance to refinance existing debt at much lower levels, saving on interest expense. Companies struggling for growth were able to borrow funds cheaply in order to fund share buybacks that boosted earnings per share results. Thanks to higher rates, these trends appear to be exhausted.
It's possible that S&P 500 profits turn out better than expected – once the Tea Party's Little Bighorn battle is over and Congress averts an international crisis – but right now there's no obvious catalyst for a positive surprise. The hurdles, unfortunately, are all too evident.
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Scott Barlow