GDP Will Finally Hit Earnings

The weak 2.5% GDP showing for the second quarter has brought dozens of new theories into the shopping bazaar of explanations about America’s growth prospects. One school says that the effect of imports on GDP is good. Imports mean that either Americans are once again consuming at a healthy level or that US businesses are increasing inventory as they expect of a wave of new customers. It is a perfectly fine theory about the benefits of consumer and business purchasing activity, if they pick up in the current quarter. Otherwise many firms will be stuck with inventory that they cannot sell, which was a substantial weight on the economy in the fourth quarter of 2008.

Other economists claim that the second quarter of 2010 was merely the nation’s business and financial activities taking a rest. On the other hand, the slowing could get worse as the government withdraws stimulus dollars, and, perhaps, moves toward austerity like many European nations.

Whatever the reason for GDP slowing, corporate earnings, the one reason for optimism about the economy in the last month, will be badly damaged when their quarterly results come out. The numbers will be particularly alarming to the stock market because so many corporations have signaled that they expert the current quarter to match the astonishing recovery posted in the first and second ones.

It has begun to become a popular statement that unemployment is not really a lagging indicator compared to GDP; the idea that unemployment was simply a footnote to the equation of the economy’s recovery. Suddenly, it is more than that. The 9.6% or 17% of  people who do not have work or have inadequate work, whichever number a given expert prefers, is an insurmountable barrier to GDP improvement.

Where does the growth come from to sustain corporate earnings for the balance of the year? The answer is “nowhere”. Earnings growth in the third and probably fourth quarters will be anemic and in some cases will not be as good as in 2009.

Companies such as  Exxon Mobil (NYSE: XOM) will probably not see the effects of the slowdown right away. There is still enough demand for production of crude and refinement. But if consumer and business spending drop, the end of the year will be the beginning of the end of easy profits.

Retailers like Walmart (NYSE: WMT) will be hit almost immediately as will advertising-based companies like Google (NASDAQ: GOOG). Financial firms with large exposures to consumer credit, real estate loans, and loans to small businesses will be hurt almost immediately. Automotive sales will also begin to drop soon, and rapidly. Airlines will suffer from a pull-back in travel.

The companies that are likely to do relatively well for the near-term are those that sell to large businesses or have products in the early stages of development. This would include Microsoft (NASDAQ: MSFT), which is still in the midst of Window 7 upgrades, and big IT suppliers including  Cisco (NASDAQ: CSCO), and Oracle (NASDAQ: ORCL). The companies may dodge a drop in earnings until late this year, or early next, but a flatlining of the economy or a reversal of the economic gains of late last year and the first five months of 2010 will damage the earnings prospects of almost every sector.

Earnings growth will begin to run in the wrong direction, and the process has already begun for some companies.

Douglas A. McIntyre