Global economic woes trigger profit warnings

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A series of ominous corporate profit warnings have marred the start of the U.S. earnings season, magnifying fears that overseas troubles are increasingly infecting North American business .

In the first few days of the quarterly earnings-reporting period, several high-profile companies have slashed their revenue and profit outlooks for the remainder of the year. Global industrial stocks, in particular, are under pressure after major U.S. equipment manufacturers Cummins Inc. and Dover Corp. each cut full-year earnings forecasts, blaming weaker than expected economic conditions not only in Europe, but also Brazil, China and the United States.

Investors had hoped that stock prices had already taken into account credit issues in Europe and a mixed economic outlook for developing markets. The negative earnings warnings, however, suggest that equity markets remain overly optimistic, and recognition of the full extent of the global economic slowdown, as reflected in lower stock prices, lies ahead.

RBC chief equity strategist Myles Zyblock believes the weak earnings outlooks confirm the steady deterioration of global economic indicators such as the purchasing managers index, which has recently fallen to below 50, a level that suggests economic contraction. Mr Zyblock expects "knock-on effects" of lower economic activity to hit commodity prices.

For Canadian investors, the significance of developments at Dover and Cummins lies less in the marginal cuts in profit forecasts than in management's observations about economic conditions in emerging markets.

Cummins CEO Tom Linebarger warned that Europe's financial instability and slower growth has spread to the developing markets, and "demand in Brazil, China and India is not improving as we had previously expected." Weaker demand for Cummins' industrial products signals a lower level of manufacturing activity, a trend likely to translate into lower commodity prices and resource-related Canadian stock values. Mr. Linebarger referred to three of the four BRIC nations that have driven demand for Canadian resources.

After the first quarter, analysts had reduced earnings expectations for the second quarter. John Butters, senior earnings analyst at Factset Research Systems, points out that analysts cut S&P 500 profit growth estimates from 6.5 per cent to 2.5 per cent for the current quarter. But the expectation has been that after a sluggish first half, corporate profits would rebound in the rest of the year – a view that may require revision if corporate guidance continues to disappoint.

Mr. Butters cautions that only 25 to 30 companies have reported results to date and it is far too early to draw broad conclusions. However, he remains concerned that "not only have far more companies than usual warned about weaker earnings, far fewer have guided higher" relative to previous periods.

But Citigroup chief U.S. equity strategist Tobias Levkovich said in a research report Tuesday that investors may be over-reacting to early earnings reports. He notes, "the analytical community has taken a knife to [earnings] numbers" to the point that "one would need a recession to be in place to expect further weakness. Critically, such troughs are usually associated with S&P [500] bottoms."

The Canadian earnings reporting season begins in earnest the week of July 24. Until then, Canadian investors can examine U.S. corporate results for more indications that weak economic data in Europe has spread to the emerging markets.