5 Questions on What Lies Ahead
Morningstar market strategist Erik Kobayashi-Solomon offers his outlook for corporate profitability, Europe, the U.S. economy, oil, and financials.
Morningstar market strategist Erik Kobayashi-Solomon recently sharpened his pencil to tackle some big-picture questions from the financial press on profitability, overseas woes, and financial-services firms. We've rounded up some of his answers below.
1. Is present U.S. corporate profitability only an illusion? Last year, profits actually increased in general for American companies. For example, in 2011, the top 100 most profitable companies in the U.S. made 13% more profits than they did in 2010. Do you think there has been a real appreciation in terms of profitability or is it just because 2010 was a bad year, and therefore even a moderate performance in 2011 appeared great?
It's not an illusion, but future profitability will rely upon a brighter employment situation. There may be some effect due to a "lapping of easy comparables" with regard to 2011 profits, but in general, we believe the profits to be genuine.
Corporations took advantage of the financial crisis in 2008-2009 to downsize their costs and have continued to focus on producing more with less ever since. Chief financial officers questioned in a recent confidence survey disclosed that they were more likely to spend money on capital projects that would increase efficiency by decreasing reliance on hiring new employees. Over the short term, this is likely to have a very positive effect on profits because: 1) capital expenditures affect cash flows, but not profitability and 2) companies are spending less in personnel costs to support an equivalent amount of revenue growth (i.e., they do not have to increase the size of their payrolls in order to meet increased demand for their goods). Longer term, companies must either begin hiring again (since unemployed people are less likely to consume goods and services) or find other markets in which consumers have adequate resources to buy their products.
2. How do you think problems in the European markets and the slowing down of emerging economies like Brazil, China, and India would hurt the outlook for companies like Apple (AAPL), Ford (F), GM (GM), and Citi (C), which rely heavily on non-U.S. markets for their growth?
This is a very difficult question to answer definitively since there are many factors involved in cross-border trade. I have recently tried to gauge the revenue dependence of S&P 500 Index companies on the European region, and even this exercise was difficult. In the end, I believe that roughly 15% of S&P 500 revenues come from Europe; I do not have numbers to back this up, but let’s say that another 5% of revenues come from emerging economies. So 20% of revenues are dependent upon European and emerging-market sales. If sales by those companies in those regions fall by 10%, that implies a 2% drag on the aggregate sales of S&P 500 companies. In other words, if "normalized" sales growth is 5% for the S&P 500, then we would expect a drop in global demand to retard sales growth to the 3% level, all else held equal.
However, in situations like this, all things cannot be held equal. Global corporations typically engage in what is called "transfer pricing," which means, for instance, that a U.S. subsidiary might sell products to its German subsidiary in such a way to maximize profit in the U.S. (a low-tax jurisdiction) and decrease profits in its German subsidiary (a higher tax jurisdiction). So lowered German demand ends up having a disproportionate effect on the U.S. subsidiary because its profits are not as high and its tax saving not as large.
As profitability drops or as executives worry about the possibility of profits dropping, they become more conservative about capital expansion and hiring plans. We have seen this effect over the last few years in the U.S. because even though U.S. profits are at all-time records, the employment market is still moribund. And as I noted above, if employment is bad, domestic consumption will likely be muted as well, unless consumers have access to easy credit (which is hard to come by since 2008).
In summary, the direct effect of a slowing Europe and emerging-markets growth is likely to be along the lines described above, but the impact on U.S. manager confidence and corporate profitability may cause secondary and tertiary effects in the U.S. domestic market.
3. How healthy is the U.S. economy? Would you say it has gotten back on its feet to be able to support the domestic demand that is so crucial for the growth and survival of U.S. companies?
What I am seeing is very much a two-speed economic recovery in the U.S. More educated, wealthier workers with greater access to credit and who have proportionally more of their wealth in the form of financial assets (like stocks and bonds) have continued to spend over the past several years, and this spending is the lead factor in boosting domestic consumption at present.
Conversely, less well-educated, less affluent workers with less access to credit and who have proportionately more of their wealth in the form of real assets (especially housing) have been working to repair their personal balance sheets and thus have been spending more conservatively. This is likely the biggest drag on domestic growth at present.
The stock market has risen sharply since its lows in March 2009, and the gain in financial assets has allowed more affluent consumers to feel more confident (contributing to a positive "wealth effect"). However, the real estate market has remained weak, and this weakness has made less affluent consumers feel less confident (leading to a negative wealth effect).
Our director of economic research, Bob Johnson, as well as other observers such as researchers at Harvard's Joint Center for Housing Studies, believe we have seen a bottom in house prices. If this is true, the negative wealth effect from low housing prices might be on the verge of a reversal, and we will see an upswing in lower-income consumer confidence.
Robust growth in housing would also go a long way in helping the employment situation, since this sector of the economy tends to employ less well-educated workers. This dual effect could create what George Soros has called a "virtuous cycle," where higher real estate prices lead to greater confidence, which in turn leads to more demand for houses and higher real estate prices, etc., etc.
4. Why are oil majors' earnings so weak? Earnings forecasts for oil companies like ExxonMobil (XOM), Chevron (CVX), BP (BP), and others for 2012 and 2013 do not appear very encouraging. Analysts and experts around the world have predicted a fall in profits for Big Oil in the years to come. Also, ExxonMobil is no longer expected to remain the most profitable U.S. company in 2012. Why is it so? And will this scenario change in the years to come?
Higher costs and lower prices are squeezing their bottom lines. All of these firms are resource extraction companies, and as such, they are subject to a greater or lesser extent on the price of the underlying commodities. ExxonMobil, for one, significantly increased its exposure to natural gas extraction, and natural gas prices are presently just coming off of a 10-year low due to a supply glut. Until the commodity price for natural gas firms up, this part of ExxonMobil's business is likely to lag in profitability.
Regarding oil, after a hundred or so years of concerted extraction, all the "easy oil" resources--the fields in which oil can be extracted cheaply--have been found and exploited. Now the most promising reserves are much more costly to extract, process, and transport--for example, deep-sea drilling, Canadian oil sands, and the like. If the cost per barrel continues to increase (as it is likely to because of this loss of easy oil effect) and the price per barrel falls or stays steady, profitability of resource extractors should reasonably be expected to fall.
As in my previous answer about Europe, there are various factors such as hedging policy that can also make a material difference in a resource extractor's profitability, especially in the short term.
5. What's the outlook for financial firms? Financial firms, which are still waking up from the mess that was created post the 2008 crisis, have started showing signs of bouncing back. It is expected that AIG (AIG), Wells Fargo (WFC), and Citi will record a brighter-than-expected 2012. In fact, estimates by analysts show how AIG is expected to become the highest profitmaker in 2012, recording a twofold jump in profits this year. How do you see the situation improving for financial firms and what is the big secret behind why AIG may do well?
It's tough to say, but I would expect lower profits in the medium term due to increased regulation and decreased gearing.
Regarding AIG, it is probably best to defer to our AIG analyst's published opinion about the firm.
"Although the U.S. Department of the Treasury recently sold more shares, the bigger news is that AIG recouped most of its deferred tax asset at the end of 2011. The release of the valuation allowance added a few dollars per share to equity, and reduces the firm's tax payments for the next few years. We have not raised our fair value estimate, as we have thought all along that AIG would eventually enjoy the benefits of the tax asset. We think it will still take some time before AIG emerges from under government control. Our forecasts for the insurance operations, aircraft leasing company and parent company interests are largely unchanged. We think AIG will not be able to earn its cost of capital over our seven-year explicit forecast, and that it will have to make quite a few adjustments in the composition of its products before that can happen." --Jim Ryan, March 22, 2012
The situation at AIG and, in fact, at other financial firms is that it is 1) hard for anyone (the firms' managers included) to know what true economic profitability is during any one year and; 2) difficult to separate actual good performance attributable to the firm's business versus good performance brought about by government subsidies.
Regarding the first point, accounting profits are estimates based upon assumptions regarding future losses and cash flows. In 2007, banks looked extremely profitable from an accounting basis, but 18 months later, they were all begging for Department of Treasury money simply to stay solvent for another day.
Regarding the second point (related to the first, obviously), AIG and all banks in the U.S. have received enormous indirect subsidies as a result of Federal Reserve actions and Congressional stimulus. So if there is a secret to profitability, it might be to be "too big to fail."
Going forward, depending on cross-border ties to European banks (via derivative contracts, counterparty agreements, and the like) and what happens to the European economy, accounting profits are difficult to predict. There is also a strong movement to regulate banks more stringently in the U.S. (Dodd-Frank, the Volker Rule, etc.), which has gained momentum over the past few months thanks to J.P. Morgan Chase's (JPM) debacle related to derivative "hedging" schemes. Increased regulatory burden and a move toward lowered gearing ratios should reasonably lead to a profitability headwind for banks. Banks may be able to counter this headwind in various ways, but if the regulations go into place, I would expect bank profitability to fall moderately in the medium term.
Erik Kobayashi-Solomon does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.