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Takeaway: Broader economic growth suffers when corporate executives broadly shift their focus to managing earnings expectations.

SUMMARY BULLETS:

  • As we have stressed in recent weeks, the 3Q12 earnings season will likely be the most dour since the Global Financial Crisis and, perhaps more importantly, consensus estimates for NTM EPS growth are simply too rich – particularly in light of aggressive margin assumptions embedded in consensus expectations.
  • As such, the direction and tone of corporate guidance will likely be as important to stock performance as it has ever been in the post-crisis period. In this regard, the next few months will definitely be a stock-picker’s environment for those seeking to meet year-end performance targets.
  • As we highlighted in recent notes, a key risk that could equate to an incremental drag on global growth over the intermediate term is an acceleration of corporate cost-cutting initiatives across both domestic and international corporations. Moreover, recent company commentary suggests this trend is already underway.

#EARNINGS SLOWING UPDATE

On our 4Q12 Macro Themes Call Monday afternoon (email us for the replay materials if you missed it live), we detailed our thesis which suggests: A) the 3Q12 earnings season will be the most dour since the Global Financial Crisis and, perhaps more importantly, B) consensus estimates for NTM EPS growth are simply too rich – particularly in light of aggressive margin assumptions amid a backdrop of global economic data that has been tepid at best/nasty at worst in recent months.

Bombed-out 3Q12 expectations provide room for short-squeezes across a number of names when they report the quarter, but we believe the broader takeaway here is just that: “where do we go from here?”. As such, the direction and tone of corporate guidance will likely be as important to stock performance as it has ever been in the post-crisis period.

#EARNINGS SLOWING UPDATE: IS CORPORATE COST-CUTTING COMING BACK WITH A VENGEANCE? - 1

We discuss the implications of “B” later in this note; for now, here’s an update on very recent developments with respect to “A”:

  • The Rio Tinto CEO says the company will defer large capital programs, as it has become more cautious about its outlook for the next few quarters, partly because of anticipated delays in Chinese stimulus efforts. The company now sees its $14B CapEx forecast for next year as a ceiling that could be reduced; moreover, it is expecting to materially reduce spending over the next few years.
  • Alcoa revised down its global aluminum growth forecast to +6%, down from +7% prior, citing a slowdown in China as a negative drag on the 2H outlook. They also updated end-market growth forecasts – most notably the Heavy Truck and Trailer segment, which is now seen coming in at -7% to -9%, which is down from a prior forecast of -3% to +1%. The company anticipates a slowdown across all major regions, particularly Europe and China.
  • FedEx announced programs aimed to increase profits by $1.7B annually by end of FY16; a significant portion of the profitability improvement will come from cost reductions at FedEx Express and FedEx Services.
  • Cummins guides FY12 revenue to come in around $17B vs. a prior forecast of $18B. They cited demand in China that has weakened in most end markets and they have also lowered their forecast for global mining-related revenues. Additionally, they guided EBIT margins to come in below previous guidance primarily due to the sharp reduction in revenues. The company is taking actions including a number of measures to reduce costs, including planned work week reductions, shutdowns at some manufacturing facilities, and some targeted workforce reductions.

While it may seem like we’re cherry-picking negative commentary (there’s always some degree of negative commentary to be found every earnings season), one would be remiss to ignore that these four companies represent a combined $147 billion in market cap. Moreover, when analyzed with respect to prior warnings given by companies like CAT, HPQ, NSC, IHS and SPLS, it’s easy to spot a trend developing here. This is a classic case of “ignore the data at your own risk”.

GLOBAL GROWTH UPDATE

Each month as a small part of our rigorous Global Macro research process, we amalgamate a broad sample of global PMI readings to get a data-driven sense of how global growth is trending on a sequential basis. The analysis includes 23 readings from 14 countries and/or economic blocs and we measure the absolute level of the indices and the sequential deltas on a median basis to produce a top-down look upon trends across the global economy.

In this light, it would appear that global economic growth slowed at a slightly slower rate in SEP vs. AUG (49.7 from 49.2); the metric does, however, remain below the 50 line, which economists use to delineate expansion vs. contraction readings. To the extent global growth continues to hang out in contraction territory on a sequential (i.e. MoM; QoQ) basis, we expect YoY growth readings to come under incremental pressure to the downside. On the flip side, the +50bps sequential  uptick reminds bears that the global economy is unlikely to slow in a perpetual straight line. There is obviously room for improvement from bombed-out levels of global economic data, but the broader callout is that any gains will be limited and the trend is likely to continue south.

#EARNINGS SLOWING UPDATE: IS CORPORATE COST-CUTTING COMING BACK WITH A VENGEANCE? - 2

WHEN MACRO MEETS MICRO

As we highlighted earlier, the key risk that could reaccelerate the rate(s) of sequential contraction across various metrics of global growth readings is an acceleration of corporate cost cutting – both domestically and globally. As was vividly demonstrated across the last corporate earnings slowdown cycle (2007-09), broader economic growth suffers when corporate executives shift their focus to managing earnings expectations (as opposed to their businesses) en masse.

S&P 500 NTM EPS growth expectations are fairly robust – as are forecasts for operating margin growth. As we highlighted on our aforementioned conference call, corporate margins are asymmetrically stretched relative to prior cycles and as a share of the economy – suggesting limited room for upside to corporate operating efficiency. In that light, where will the revenue growth needed to meet such aggressive out-year margin expansion expectations come from if a large contingent of international corporations engage in reducing SG&A and CapEx at roughly the same time?

#EARNINGS SLOWING UPDATE: IS CORPORATE COST-CUTTING COMING BACK WITH A VENGEANCE? - 3

That’s a question we aren’t sure anyone has an answer to at the current juncture. What we do know is that corporate executives know full well what is being asked of them with respect to NTM forecasts. That will put a tremendous amount of pressure on companies to A) cut guidance (CMI); B) cut costs (FDX); C) do both (RIO); or D) pretend everything is generally fine and hope for a resurgence in demand (AA).

At any rate, the next few months will definitely be a stock-picker’s environment for those seeking to meet year-end performance targets.

Darius Dale

Senior Analyst