Here comes the earnings recession: James Saft

By 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.

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