Here comes the earnings recession: James Saft

LONDON (Reuters) - Even if economic growth stays positive, a transatlantic recession in corporate earnings is an increasing possibility for 2008, setting up further disappointment for equity investors.

Earnings growth in Europe and the U.S., at lofty levels by historical standards, faces a squeeze from sluggish, or even negative, overall economic activity combining with businesses' inability to pass on rising costs for things like energy to consumers.

While there has been a sharp down rating of U.S. earnings estimates for the first half of 2008, on a bottom-up basis analysts are still forecasting year-on-year growth of 15.3 percent among the S&P 500 for 2008 as a whole, according to Reuters Research.

Similarly, expectations have been high in Europe, with 7.4 percent forecast for the FTSE 100 for fiscal year 2008, an 8.8 percent gain for companies in Germany's DAX and 12.4 percent for those in France's CAC-40.

That bottom-up optimism has helped to shield equities from the full force of gloom emanating for the credit crunch and the rising perception that the United States will fall into recession.

Tim Bond, head of global asset allocation for Barclays Capital in London, says that while analysts have scaled back their expectations for U.S. corporate earnings, they've not gone far enough and their bets on a recovery of momentum in the second half are too bullish.

Bond says corporate profitability has shrunk rapidly according to the U.S. national account data, which measure a wide swathe of businesses that are often a leading indicator for listed company profits.

"On a very macro level, profit margins have started to narrow in the context of softer growth," he said.

"Cost growth has been higher than output price growth for about a year, and, allied with a slowdown in nominal GDP growth, means profits have gone from positive to negative."

Companies in the U.S. have not only been hit by higher financing costs, the costs of materials such as commodities and energy have risen more than can be successfully passed on to consumers. Add in slowing, or even negative, growth and the picture dims.

Corporate profits from current production decreased by $20.5 billion in the third quarter, in contrast to an increase of $94.7 billion in the second, according to data from the U.S. Bureau of Economic Analysis.

"Overall profits are very, very weak," said Bond, who is forecasting year-on-year declines in S&P 500 earnings of 5 percent and 15 percent in small cap shares through the third quarter.

"To factor that in, the stock market needs to come off from year-end levels by 10-15 percent."

And remember, too, that analysis is not based on a recession, but on weak growth.

EUROPE TO CATCH U.S. FLU?

Can Pan-European earnings remain strong even as the U.S. sags?

Not if you take results from Britain's Marks & Spencer (MKS.L) as any guide.

Britain's biggest clothing retailer was singing a tune that will be familiar to investors in U.S. retail when it announced its worst quarter in two years on Wednesday, sending its shares down by as much as 20 percent. M&S said it had been forced to slash prices to entice heavily indebted shoppers to continue spending.

"If you reduce the price of cashmere to 49 pounds from 69 pounds, you have to sell a hell of a lot of cashmere to make up for the fall," M&S chief executive Stuart Rose said.

Morgan Stanley is predicting a one percent decline in European earnings through year-end. The bank, which is predicting a U.S. recession, notes that earnings usually fall to below their trend levels of growth in recessions.

"In fact, we've seen an earnings bubble of record proportions: European earnings in real terms are an unprecedented 83 percent above trend, while in the U.S. real earnings are 73 percent above trend (a level only exceeded in 1917)," analysts Ronan Carr and Edmund Ng wrote in a note to clients.

That would imply quite a substantial fall; both in earnings and share prices.

Morgan Stanley posits that earnings recessions usually have a peak-to-trough fall of 40 percent over 20 months and an associated 33 percent fall in equities.

"We believe an earnings recession is not fully in the price," wrote Carr and Ng, who define earnings recessions as periods where corporate profits fall from above to below their trend level of growth.

In reality, a gap between what top-down strategists expect during a downturn and the sanguine views of company analysts is pretty typical. My money would be on the strategists. During the dot com bust in 2000 and 2001, analysts stayed resolutely upbeat about European earnings even as they were falling sharply.

This time could be different, but it would be a brave bet.

(James Saft is a Reuters columnist. The opinions expressed are his own. At the time of publication Saft did not own any direct investments in securities mentioned in this article. He may be an owner indirectly as an investor in a fund. You can email him at jsaft@reuters.com and find more columns here)

(Editing by Ruth Pitchford)