Corporate Profits First Annual Drop Since 2008

March 28, 2015 2 Comments

Yesterday, the biggest news in financial markets was the final revision for Q4 2015 GDP numbers. Considering that the final revision was relatively unchanged from the preliminary numbers, there wasn’t much to analysis or discuss in relation to these statistics. Instead, we were given statistics for the quarterly Corporate Profits from current production (corporate profits with inventory valuation adjustments (IVA) and capital consumption adjustment (CCAdj)), and what we’ve found was interesting.

For the year 2014, corporate profits from current production decreased $17.1 billion, compared to an increase of $84.1 billion in 2013. Aside from this and the average GDP numbers we just got yesterday, this confirms that the US economy is once again slowing down. Economist and market economist have already started to revise their GDP estimates for Q1 2015 downward. So much so, that the Federal Reserve Bank of Atlanta has decided to lower their GDP estimates for Q1 to just 0.1%.

Declining profits is also not what the EPS advocates would like to see. Lower profits would most likely mean lower job numbers for months to come. That is, unless we can somehow increase productivity for the upcoming financial quarters, but that doesn’t seem very likely.

This decline seemed to be concentrated in the domestic financial sector, rather than the non financial sector. Profits from the rest of the world were also down, which can easily be explained by the surge in the US dollar. Wouldn’t growth in the value of the dollar be seen as a good thing for profits? That all depends.

First, The Federal Reserve has had a very expansive monetary policy known as Quantitative Easing, which involves the purchasing U.S. Treasury bond and mortgage-backed securities. The Fed’s massive buying of Treasuries and MBS within the past seven years meant a larger demand for those bonds, and since the interest rate for bonds move the opposite to their price, rising bond prices means falling interest rates (and vice versa). Now with the increasing anticipated rate hike from the Fed  this would decrease the demand for bonds. Considering the very weak economic data we’ve been getting as of late, we’re not likely to see an increase in interest rates as of yet.

So, what exactly is increasing the US dollar? That’s where foreign investors come in. Other nations are either on a path to monetary stimulus or have already started their own QE projects. Japan is vigorously using their monetary policies to growth their economy and combat inflation. The Swiss and Danish National Bank andThe Riskbank, are all experiment with negative interest rates. Not to mention all the central banks around the world are flirting with record low interest rates.

Given the nature of this economic environment, investors want a place where they can earn a return without inflation eating away at your return. Right now, it seems like the best option is to buy assets in U.S. denominated currency. This is mostly in the form of U.S. Treasury bonds, but also in U.S. equities. Because of this, the U.S. dollar is increasing in value, as a strong dollar increases foreign demand for dollar denominated assets.

What does this have to do with Corporate Profits? For one, it makes exports more expensive for foreign customers, as you have seen in previous GDP estimates. A stronger U.S. dollar has the potential to hurt U.S. corporate profits. The more business a company does abroad, the more it will hurt, which explains the decline in Corporate profits in the rest of the world.

Overall, the negative effects are just beginning to unravel in the marketplace. Considering the Federal Reserve is unclear on whether to raise interest rates this year, the strong dollar environment suggest that money will continue to be attracted to the U.S. stock market, especially stocks whose sales are primarily domestic, and Large-cap, blue-chip stocks. Despite constant gyrations in the marketplace, large cap indices such as the NASDAQ/S&P 100 have already begun to outperform the marketplace. Unless you’re planning on investing in mega/large cap corporates, you should avoid adding companies that obtain a large portion of their revenue overseas. 

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