M Macys Inc

By Michael Wursthorn 

Investors counting on a corporate earnings rebound in the second half of the year are risking disappointment.

Wall Street analysts have cut their third-quarter profit estimates in recent weeks, painting a bleak picture for investors already grappling with a simmering trade war, pockets of economic weakness and ominous signs from the bond market.

Despite this week's partial reprieve from the Trump administration, the latest round of tariffs on Chinese imports compound the problems already facing many companies and threaten to stifle their profit margins. Especially vulnerable are manufacturers, miners and retailers.

At best, earnings across the companies in the S&P 500 will grow 1.5% this year, FactSet projects, far short of estimates for growth of more than 6% that analysts initially forecast in January. Worse, a few analysts predict earnings could end up contracting for 2019 as a whole.

Dozens of companies including Eastman Chemical Co., Macy's Inc. and Caterpillar Inc. have issued downbeat outlooks for the rest of the year, contributing to the pullback in profit expectations.

"Everyone in April and through the beginning of May thought that the economy was going to get better in the back half of the year, trade war was going to sort of settle, certainly not escalate," Eastman Chemical Chief Executive Mark Costa said on an earnings call last month. "And now we're just in a very different world where I don't think that's true....There's not a lot of signs of economic recovery coming in the second half."

To be sure, surprises to the upside are fairly common with earnings reports because analysts tend to be conservative with their estimates. The first and second quarters were no different in that regard.

Analysts said investors shouldn't take the slowdown in earnings growth lightly, especially as the outlook for later quarters dims. Hanging over the stock market is a diverging U.S. economy. Manufacturing activity in the U.S. has slowed for four straight months. Service activity, which includes companies in the health-care, finance and restaurant industries, has held up better as Americans maintain a solid spending appetite and as employment remains strong.

Although U.S. growth is slowing, it is holding up better than other parts of the world. The latest economic figures out of China showed its jobless rate in cities hit a record. Europe is also stumbling as Germany said its economy shrank last quarter.

A healthy U.S. economy is important, but corporate profits are the real engine behind stock market gains, said Yana Barton, a portfolio manager at Eaton Vance. Stocks tend to meet less resistance if earnings growth is robust, keeping valuation metrics such as price/earnings ratios in check. Instead, P/E ratios drifted as high as 17.5 last month, which is considered somewhat expensive as earnings growth flatlined, she said.

Without profit expansion, stocks could be more susceptible to bouts of volatility, especially when investors have been grappling with trade tensions for more than a year, along with signs that economic growth in the U.S. is slowing.

"There are times we've been aggressively positive, but we haven't been that way over the last year," said Ed Keon, chief investment strategist at QMA LLC. The bleak earnings outlook and a wide range of geopolitical issues contribute to his cautious view, he said. In response, he said he has been hedging his exposure to stocks by buying bonds.

The S&P 500 has slumped 4.7% in August, including Wednesday's 2.9% drop, leaving the broad index roughly where it was 12 months ago. And moves in the bond market have signaled an economic slowdown could be on the horizon.

Ms. Barton said stocks would have a catalyst to move higher if the U.S. and China were to reach a trade deal or if economic data improves. The S&P 500, for example, logged one of its best days in months on Tuesday after the U.S. decided to delay some of the tariffs it planned to impose next month.

But that decision doesn't fully alleviate concern or the cost pressures that have already mounted on companies, analysts and investors said.

Analysts' latest revisions show the S&P 500 faces a 3.15% contraction in third-quarter earnings from a year earlier, according to FactSet. And for the fourth quarter, the S&P 500 is now on track to increase profits by less than 4%, down from the nearly 10% growth rate analysts expected at the beginning of the year.

Macy's, for one, lowered its earnings outlook for the year Wednesday, pointing to a buildup in inventories. Tariffs on some Chinese apparel imports are expected to further strain the department store chain.

In some cases, companies are mitigating the costs of trade tariffs and the paralyzing effect they are having on business spending. But that isn't always reflected in share prices.

Scotch tape maker 3M Co., for example, cut production and reduced inventory because of waning industrial demand. Those moves helped it beat second-quarter profit estimates, but shares are down 17% this year.

Procter & Gamble Co., meanwhile, reported higher sales after raising prices, bucking some of investors' concerns regarding mounting costs. Shares have risen 26% this year and have only slid 1.9% so far this month.

Tariffs aren't the only factor to blame for the weaker outlooks. Second-quarter profit margins across all S&P 500 sectors are down from a year earlier, according to FactSet. Rising labor and commodity costs, as well as a strong dollar, have helped to dent profits.

Caterpillar, for example, cut its profit forecast last month, blaming higher labor costs, as well as trade tariffs. Its shares have fallen this year after notching steep declines this month.

"Caution is warranted as you look out to the end of the year," said Terry Sandven, chief equity strategist at U.S. Bank Wealth Management. "There's still a reset in motion that will result in earnings being lower than what's expected. It's one reason why we think the market goes sideways from here."

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Write to Michael Wursthorn at Michael.Wursthorn@wsj.com

(END) Dow Jones Newswires

August 15, 2019 05:44 ET (09:44 GMT)

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