Investors have been enjoying a snappy stock-market rally this summer, but there's trouble behind the confetti.
Second-quarter earnings at big firms were strong, but there are some worrisome signs that analysts hadn't expected. Top-line revenue at many firms was weak, which means companies sustained profitability by cutting costs—including labor. That's bad news for the economy, because it suggests layoffs may pick up while business spending slows down. Three years after the recession officially ended, the opposite should be happening.
Many companies also lowered their guidance for revenue and profit over the rest of the year. Of 94 big firms that issued guidance during the second quarter, 67 lowered their sales or earnings projections, according to S&P Capital IQ, and only 19 raised them. If those downgrades turn out to be accurate, corporate profits in the third-quarter could be the weakest since 2009.
That's bad news for President Barack Obama's reelection bid. Strong corporate profits have been one of the economy's few bright spots, and that in turn has pushed the stock market sharply higher over the last three years. If the rally were to run out of steam, Obama would have even fewer economic success stories to sell to voters. Third-quarter earnings will start rolling in around the beginning of October, leaving plenty of time before the elections for weak earnings, if they materialize, to push stocks lower.
S&P Capital IQ scoured second-quarter earnings reports and remarks by CEOs to determine why business leaders seem so pessimistic. Here are the top concerns:
The European debt crisis. Though Europe has been in a slow boil for several years, CEOs seem to sense that a moment of reckoning is coming, perhaps as Greece leaves the euro zone, which could incite a financial panic in Italy and Spain as well. Even if that doesn't happen, Europe seems headed for a recession and may already be in one. Companies ranging from McDonald's to General Motors to Royal Caribbean Cruises all said the slowdown in Europe has hurt business so far this year.
Rising commodity costs. Inflation has been tame, and the cost of many commodities that companies rely on as inputs fell earlier this year. But energy prices, including oil, have since been rising, and the U.S. drought seem likely to drive the cost of many food products higher. CEOs may be worried that earlier cost-cutting due to lower commodity prices will be unsustainable, forcing more painful cuts elsewhere.
The slowing Chinese economy. Multinational companies don't just build stuff in China anymore. They also sell goods and services there. In fact, China and its booming consumer class have become a major source of growth for a lot of western companies. The problem is that China's torrid growth has slowed as the weak economies of Europe and the United States have reduced demand for China's exports. There may also be a property bubble in parts of China, causing China's own consumers to hunker down. That's a hit for many companies that have relied on strong growth in their sales in China to offset weak sales elsewhere.
One thing that didn't come up in many companies' official earnings statements was the "fiscal cliff" that looms in Washington, as lawmakers must decide what to do about $700 billion in tax hikes and spending cuts scheduled to go into effect at the start of next year. The Congressional Budget Office warned recently that if Congress does nothing, and all of those measures go into effect, the economy will shrink, unemployment will rise and another recession will ensue.
But business leaders did pipe up about the fiscal cliff when asked about it by analysts or journalists on earnings calls. Executives at Caterpillar, Procter & Gamble and J.P. Morgan Chase cited the looming political showdown as one of their top concerns. Others said they're worried about it, but haven't yet noticed a slowdown in orders or other measurable indicators that would lead them to downgrade earnings forecasts.
Meanwhile, Bank of America Merrill Lynch predicted recently that the odds of a crisis related to the fiscal cliff have increased, mainly because the two political parties seem to be drifting further toward the extremes, making them less willing to compromise. "We continue to believe the economy is in the eye of the storm," the firm's economists wrote in a report to clients. That's not a place where many CEOs—or ordinary consumers—want to be.
Rick Newman is the author of Rebounders: How Winners Pivot From Setback To Success. Follow him on Twitter: @rickjnewman.