• Wealth Management

Why U.S. Corporate Profits Could Shrink

First-quarter stock market gains were impressive, but the outlook for U.S. corporate earnings isn’t so rosy.

Stock market returns have been heady so far this year, with the S&P 500 up 17% in the first quarter. With accommodative Federal Reserve policy helping to stabilize markets after last December’s selloff, many investors are optimistic that the gains will continue.

I’m not convinced for one important reason: Investors generally seem to be ignoring the weakening conditions for corporate profit growth. First-quarter earnings season is just starting, and we could see the beginning of an earnings recession, defined as two consecutive quarters of declining profits.

While many investors currently seem emboldened to take risks, I think this may prove to be a good time to take profits instead—especially in overvalued sectors, such as technology. Below are three key reasons why I think first-quarter earnings are likely to be weak and why that may not be temporary:

  • Lower sales growth: The global economic slowdown lingers and European demand in particular has been worse than expected. A stronger U.S. dollar in the first quarter may crimp reported sales of tech and multinationals, as foreign currencies are translated into dollars.

  • Higher costs: With the tight U.S. job market, companies are paying more for labor and benefits. Meanwhile, oil, another major cost for many industries, is up 36% from the start of the year. Companies seem unable to counter these rising costs with higher prices, which means that lower profit margins are all but inevitable.

  • Shrinking capital spending: Capital investment grew nicely in 2018 (up 7% annually), but I don’t see room for continued gains ahead. Surveys done by the National Federation of Independent Business show that many small-business owners plan to spend less, which can be an accurate early indicator of slower capital expenditure ahead. Productivity gains, which can boost profit margins, are highly dependent on capital spending.

Today’s higher valuations wouldn’t be a problem if earnings were likely to grow. Instead, I see vulnerable profit margins and growth rates. My suggestion is for investors to take profits in areas that may be overvalued. Tech holdings are worth reviewing for negative profit trends, as earnings season gets underway.

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