An economic "soft patch?" Someone forgot to tell the corporate sector.
Despite slowing growth in gross domestic product as well as other sluggish economic indicators, the picture for corporate profits remains rosy as companies prepare to report their results for the second quarter of the year. Alcoa Inc., traditionally the first major U.S. company to report each quarter, will kick off the earnings parade after the market closes Monday.
Bay Street analysts are calling for year-over-year profit growth of a stunning 52.3 per cent for the companies in the S&P/TSX 60, according to data from market research firm FactSet - in a quarter when Canada's economy is estimated to have grown at an anemic annualized pace of about 1.7 per cent, less than half the rate of the first quarter. U.S. profits are estimated to have grown by 13.2 per cent - still about double the historical norm.
"This goes down as being tied for the weakest post-recession recovery on record in the United States, yet earnings have been absolutely mind-boggling in terms of their strength," said David Rosenberg, chief economist at Gluskin Sheff + Associates Inc.
Despite the apparent discrepancy, market experts say there are good reasons why profits can thrive when the economy isn't. Earnings of companies that make up the Canadian and U.S. stock markets are driven by different factors than the overall economy - and some of those factors have been accentuated during the current recovery.
"The stock market … is not a reflection of the overall economy," said George Vasic, chief economist and chief strategist at UBS Securities Canada Inc.
Resource companies, enjoying a sustained profit boom amid strong demand and prices for metals and oil, make up fully half of Canada's benchmark S&P/TSX composite index, but account for only 11 per cent of the country's GDP and less than 8 per cent of its employment, he noted. Conversely, consumer-related stocks account for just 7 per cent of the S&P/TSX composite, even though consumer spending makes up nearly 60 per cent of GDP.
"The consumer part is vastly under-represented [in the stock market]" he said.
Mr. Rosenberg noted that the consumer side of the economy is under-represented in other ways as well, because stocks are driven by business earnings - not labour earnings. Wages make up more than half of Canada's GDP on an income basis, and were nearly five times the size of corporate profits last year.
"The lion's share of gross domestic income is the labour component. That has performed absolutely miserably [in the U.S.]this cycle," he said. "But the share of income devoted toward the corporate sector has been doing just fine."
The surge in corporate profits over the past year has stemmed, in part, from keeping a lid on labour costs - the combination of job cuts in the recession and the sluggish U.S. labour market has kept total payroll expenses down even as revenues have rebounded. Since labour is typically the biggest expense for any company, Mr. Rosenberg said, the weak labour market "allows [firms]to keep their margins nice and fat."
"It's absolutely wonderful news for the capitalists," he said.
That translates to a gap between the corporate sector and the economy when it comes to expenditures. While the weak labour market has restrained consumer spending in the United States, strong profit margins and low interest rates have encouraged business spending. David Bianco, chief U.S. strategist at Merrill Lynch in New York, noted that business spending is the key driver of profits among big U.S. companies, but consumer spending drives the bulk of U.S. economic activity.
"The S&P's end markets and its business exposures are very much not the consumer," he said.
Experts noted that much of the S&P 500's profit recovery has been fuelled by overseas markets that have had healthier economic growth than the U.S. and other Western economies. More than half of the S&P's revenues are derived from markets outside the United States.
"They can continue to report strong sales and revenue growth overall, even while the U.S. economy is growing at a slow pace," said John Butters, senior earnings analyst at FactSet.
Nevertheless, Merrill Lynch's Mr. Bianco said there are signs the market is becoming more cautious on earnings expectations. He noted that based on forecast 2011 earnings, the S&P 500 is trading at a historically cheap 13.5 times price-to-earnings ratio, despite dirt-cheap interest rates that would normally imply higher-than-normal P/E valuations.
"The disconnect between P/Es and interest rates can only be explained by two things: Either that people think that interest rates are going to surge, or that the earnings are unsustainable," he said. "I do think the market expects good earnings in the second quarter, but the market has been very cautious about the risks."
By the numbers
* Percentage of natural resource stocks in S&P/TSX composite: 50%
* Percentage of natural resource industries in Canadian GDP: 11%
* Percentage of financial services stocks in S&P/TSX composite: 29%
* Percentage of financial services industries in Canadian GDP: 21%
* Percentage of consumer stocks in S&P/TSX composite: 7%
* Percentage of consumer spending in Canadian GDP: 58%
Sources: UBS, Bloomberg, Statistics Canada