On Earnings and Economic Growth

Story Highlights:

• US Q2 2011 earnings have been a pleasant surprise to investors.
• But weak employment figures have many wondering when economic growth will catch up.
• Looking forward, expect earnings growth to diverge between sectors and categories, but overall, remain positive on the strength of the global economy.

The Q2 2011 earnings season kicked off recently and has thus far been a pleasant surprise to investors. But strong corporate earnings growth also has many wondering when the US economy’s supposedly tepid growth will catch up.

As of 7/22/2011, 143 S&P 500 companies have reported earnings for Q2 2011, and 88% have met or surpassed expectations. In a typical quarter, the figure is around 80%. Analysts estimate the Q2 2011 earnings growth rate for the entire S&P 500 will clock in at 9.2%—and, if so, that’ll mark seven straight quarters of growth.* Rising profits actually say quite a bit about US and global economic growth as well. While many contend earnings growth has been driven primarily by corporate cost cutting—and in the early stages of this expansion and bull market, that was clearly true and perfectly normal—S&P 500 top-line revenue grew for all of 2010 and continued in 2011, including Q2 to date. In other words, earnings are rising in part because corporations have kept costs relatively low, but also because consumers have, in increasing numbers, begun buying again as the economy has grown (in fact, its larger than it’s ever been before).

All the while, many have bemoaned what they feel is a sluggish economy weighed down by lack of consumer demand. Most seemingly tie this to the stubbornly high unemployment rate. The perception is corporations are sitting on record cash balances, yet many haven’t begun hiring (and some are still cutting). While there might be some truth to this, it’s important to see it for what it is—a likely temporary phenomenon tied to exceptional productivity gains of the last recession, and a lack of corporate appetite to expand workforces ahead of significantly tight capacity. Truth be told, though, this time is no different than ever before in history—unemployment has increased and remained high after every recession we can measure. Material improvements in employment figures typically lag the onset of recovery by months or even years.

However, companies know they won’t be able to hold onto their cash forever and still meet global demand using a bare-bones workforce. And those companies, seeking to boost profits to placate investor demand, will likely be forced to materially increase their workforces eventually. Some fear this means lower profit growth ahead—which it may to some degree. But it’s no small irony folks fret slow hiring (largely driven by productivity gains), and then fret the productivity gains will taper off.

Similar to unemployment, some point to the source of earnings growth as a sign of weakness. Much of the earnings growth in the past several quarters has come from foreign marketsfaring better thus far in the current economic expansion. However, that there are strong parts of the global economy propelling the earnings growth of US companies should point to the fact positive economic fundamentals in strong growing countries can—and should continue—propelling the global economy forward. Strong economic growth abroad isn’t a weakness—it’s demand.

Like stock returns, earnings haven’t been uniformly distributed across sectors and categories. And as we roll into the second half of the year, this is likely to only become more differentiated. But overall, that corporate earnings growth continues to be strong should demonstrate the resilience of the global economy in the face of many economic fears so widely discussed.

* Source: Thomson Reuters, “This Week in Earnings,” July 22, 2011. Bloomberg, L.P.