(Insider Stories) - While the U.S. earnings season has kicked off with better-than-expected results from Alcoa, margins are stretched by past standards and there is a clear risk that profits will grow less rapidly than output over the next few years, even as the economic recovery gains traction, capping the upside for stocks, London-based research provider Capital Economics says.

The following is an extract from the report.

Key Market Themes

The US Q2 earnings season kicked off on Monday with some better-than-expected results from Alcoa. However, we suspect the news is likely to be less upbeat in the coming weeks and beyond. Margins are now very stretched by past standards, so there is a clear risk that profits will grow less rapidly than output over the next few years, even as the economy recovery gains traction. This need not result in falling stock prices if valuations continue to rise. But it is likely to cap the upside.

The earnings reported by companies in the stock market differ from the macroeconomic profits that are the basis of our analysis. This is primarily due to the effects of accounting treatment, coverage, dilution and taxation. That being said, the growth rates of macroeconomic profits after tax in the US non-financial sector (including foreign earnings retained abroad) and S&P 500 operating earnings per share have still tended to track a similar path historically. (See Chart 1.)

One frequently-cited measure of earnings published by the Bureau of Economic Analysis is domestic profits from current production before tax. In the non-financial sector, such “narrow” profits were 14.0% of value added in Q1 – the lowest share since Q3 2011. Admittedly, the share has not collapsed. But after rising sharply in the early phase of the recovery, it has trended sideways for most of the past two years. (See Chart 2.)

What’s more, a further decline in the profit share is overdue. There were nine official recessions since the early 1950s prior to the last one that ended in June 2009. On average, the cyclical peak in the share occurred about eleven quarters after the end of each downturn. The last recession ended sixteen quarters ago.

That said, the profit share may hold up better than it has in the past. After all, structural changes that have put upward pressure on the share – such as the effects of globalisation – are unlikely to disappear. Nonetheless, we would be surprised if cyclical forces did not prompt the share to fall over our forecast window.

If this happened, earnings would grow more slowly than output, which means that further gains in the stock market would depend on increases in its price earnings ratio. However, the latter has already risen to a high level. The ten-year cyclically-adjusted price/earnings ratio of the S&P 500 has increased from around 13 in the spring of 2009 to more than 23 today, which is eight points or so above its geometric average since 1900.

Granted, the stock market may look less overvalued once revised GDP data have been published at the end of July. This is because the revised data will treat “intellectual property products” – such as corporate outlays on intangible assets (which have grown very rapidly in recent decades) – as investment rather than earnings-reducing expenditure. And even if the price/earnings ratio of the stock market still appears stretched once these revised data have been published, it could conceivably rise much further. After all, it eclipsed 44 at the peak of the dot com bubble. (The standard price/12m trailing earnings ratio also appears less stretched relative to its own long-run average.)

Still, history suggests a decline in the cyclically-adjusted price/earnings ratio is more likely than a rise once the profit share has peaked. In the nine economic cycles since the 1950s prior to the last, the ten-year cyclically-adjusted price/earnings ratio fell by an average of 0.4 points in the twelve months after the peak in the profit share. What’s more, the price/earnings ratio has risen by an unusually large amount in this cycle from its trough, providing it with greater room to fall.

With this in mind, our forecast that the S&P 500 will end next year at 1,675 may appear a little perplexing. But this forecast is only around 2% higher than the index’s current level – significantly less than the likely increase in nominal output over this period. Our forecast therefore allows for some combination of a small drop in profit margins and in the index’s price/earnings ratio. (John Higgins)

Meanwhile, the IMF has cut its world GDP forecast for this year and next by 0.2 percentage points, to 3.1% and 3.8% respectively. As it happens, we are also just publishing our latest global forecasts. (See our Global Economic Outlook, to be sent shortly to clients of our global economics service.) For this year, there is now very little difference between our forecast and the IMF’s: we are projecting global growth of 3.0% rather than 3.1%. However, we are forecasting only a very gradual acceleration in 2014, to 3.3%, so the IMF’s 3.8% still looks too optimistic to us. The IMF is particularly hopeful about the euro-zone, where it expects a decent recovery, and China, which it expects to sustain steady growth of 7.7% or more, whereas we expect Chinese activity to slow further. (Andrew Kenningham)

What to watch for today: North America

The minutes of the last FOMC meeting (19.00 BST) are expected to provide more details on the Fed’s provisional plan to taper the pace of its monthly asset purchases later this year and end the purchases completely in the middle of next year. We expect they will support our view that the tapering will begin in September. The minutes may also provide some information on the size of the initial tapering and the Fed’s latest thinking on whether, some years down the line, it will reduce the size of its balance sheet by selling Treasuries. In contrast, we expect Fed Chairman Ben Bernanke’s speech in Boston (21.10 BST) on “A Century of US Central Banking” to be largely backward-looking. But Bernanke may take the opportunity to join other Fed officials in suggesting that the recent rise in Treasury yields has gone too far. (Paul Dales)

Japan

The June survey of consumer confidence (06.00 BST) is likely to show the headline index holding close to its recent highs. Admittedly, the Economy Watchers Survey for the same month, released on Monday, fell sharply. The Nikkei was also relatively weak when the consumer survey was taken, suggesting the risks are on the downside. Nonetheless, the EWS tends to be more volatile, while consumer confidence should be helped a bit by the rebound in summer bonuses. It will also be interesting to see what the consumer survey has to say about inflation expectations, which have been rising strongly. (Julian Jessop)

China

The fifth round of the US-China Strategic and Economic Dialogue is scheduled to be held in Washington, D.C. today and tomorrow. Expectations for significant policy announcements to follow are low.

Meanwhile, today’s trade data will probably show that growth in both exports and imports rose in June, with unfavourable base effects having faded. The lending data are also scheduled to be released at some point in the next few days. Local media reported that bank lending started June extremely strong. This appears to be a key factor in the ensuing cash crunch, which should have caused a sharp pullback in lending in late June. The net result is anybody’s guess. Data on foreign exchange reserves for Q2 will also be released at the same time. Our estimates suggest that they continued to pick up last quarter, although at a slower pace than they did in Q1.

Finally, Tuesday’s CPI data showed that inflation picked up from 2.1% y/y in May to 2.7% last month, as a result of increases in vegetable and pork price inflation, while core inflation fell. Although a further rise in headline inflation is likely on the back of the continuing rebound in pork prices, it is unlikely to stretch too far given the weakness of underlying demand. We continue to think that headline inflation will stay below 4% for the rest of this year. If we are right, it is unlikely to be a major concern for policymakers. (Qinwei Wang)

Key Data and Events

Wed 10th      -     Chn  Trade Balance (Jun)

              -     Chn  Exports (Jun)

              -     Chn  Imports (Jun)   

            00.00   Kor  Unemployment Rate (Jun)     

            00.50   Jpn  DCGPI (Jun)     

            00.50   Jpn  Tertiary Industry Activity Index (May)  

            06.00   Jpn  Consumer Confidence (Jun)   

            07.00   Ger  CPI (Jun Final)  EU Harm.

            07.45   Fra  Current Account (May)

            07.45   Fra  Industrial Production (May)

            08.00   Den  CPI (Jun)  EU Harm.

            08.30   Tha  Interest Rate Announcement  

            09.00   Ita  Industrial Production (May)

            09.00   Nor  CPI (Jun)

            11.00   Por  CPI (Jun)  EU Harm.

            19.00   US   Fed FOMC Minutes (18-19th Jun Meeting)

              -     Brz  Interest Rate Announcement