After a bumper 2021, companies might struggle to increase profits

The profits engine that drove stocks to their highs, making many Americans feel richer than they had in a generation, may now be working in reverse.

Companies like Snap, Cisco Systems, Deere, Walmart and Target have cautioned investors about challenges that their businesses are facing, sending their stocks sharply lower and contributing to a plunge that has knocked the S&P 500 index down about 13% from its January peak.

Big declines in the stock market occurred after investors began to fear that the Federal Reserve would slam the brakes on the economy to tame inflation by raising rates and ending its asset purchases. The central bank’s moves could crater corporate earnings, the thing that investors ultimately care about most.

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Investors hope that the Fed could achieve a soft landing, bringing down inflation without widespread economic damage. But the recent spate of lackluster corporate financial reports suggest that the economy has already made a turn for the worse — and that more companies will announce slowdowns in their business.

“There’s a tremendous amount of uncertainty,” said Mike O’Rourke, chief market strategist at JonesTrading. “I think things are going to weaken.”

Snap, known for its Snapchat app, warned investors last week about an abrupt souring in its business, which is almost completely dependent on selling ads. “Since we issued guidance on April 21, 2022, the macroeconomic environment has deteriorated further and faster than anticipated,” Derek Andersen, Snap’s chief financial officer, wrote in a financial filing. Its stock is down 31% since the news.

Such warnings come after a year of record profits across corporate America.

Loose monetary policy and high government spending helped many companies in the S&P 500 in 2021. And some businesses posted higher profits because prices for goods that were in high demand and short supply went up a lot, often more than making up for the fact that the companies sold fewer goods.

Profits for companies in the S&P 500 were up 70% from 2020 — a rebound from the depressed earnings early in the pandemic — and 33% higher than in 2019, which was a pretty good year for corporate profits.

But something else happened last year to create the bonanza — and that development could now be unwinding.

A New York Times analysis of over 2,000 publicly traded companies outside the financial sector found that most of them increased sales faster than expenses, a remarkable feat when the cost of wages, raw materials and components was rising and supply chains were out of whack.

As a result, profit margins rose well above the pre-pandemic average. On the whole, companies made an estimated $200 billion in additional operating profits last year because of that increase in margins.

The windfall sent stocks surging in a wave of market exuberance but potentially beyond what business fundamentals merited. The price-to-earnings ratio — an indicator of how much investors are paying for each dollar of corporate profit — for all of the companies in the S&P 500 climbed to 23 at its peak, compared with an average of 18 for the decade before the pandemic. At such an elevated price-to-earnings ratio, stock prices were particularly vulnerable to a sell-off.

And now there are good reasons for investors to be concerned about profits. Many federal stimulus programs created during the pandemic have ended or are ending. The Fed is raising interest rates. And corporate executives are warning that the supply chain problems that may have helped them boost profits last year have become a burden.

Deere, the maker of agricultural, construction, gardening and other equipment, said that materials costs were still rising, and that it lacked parts to complete certain products, delaying sales. Cisco, which makes computer networking equipment, also complained that it couldn’t get certain components.

Particularly worrisome to investors are signs that demand for some goods and services is flattening or even falling. Walmart noted that higher food costs appeared to have reduced demand for other items. And while Target expected demand for apparel and home goods to fall as the government stimulus wore off, the company “didn’t anticipate the magnitude of that shift,” CEO Brian Cornell said.

Shares for the clothing retailer Gap fell sharply last week after it announced disappointing earnings for the first three months of the year, as well as a more pessimistic outlook for its profits through the rest of 2022. The firm was greatly affected by a deep decline in sales for its Old Navy brand, which tends to appeal to lower-income consumers because it carries lower-priced merchandise than Gap stores.

“We’re dealing with really volatile consumer signals — whether it was last year in COVID, or this year’s post-COVID behaviors,” Gap CEO Sonia Syngal told CNBC in an interview.

Many retailers are confronting a similar challenge: Larger inventors and lower sales are pushing them into discount goods, depressing profit margins. Effectively bad news for companies’ profits could be good news for the inflation outlook as prices for at least some goods fall back to earth.

That said, many companies did well in the first three months of the year and have offered upbeat projections about the rest of it.

Only 97 of the companies in the S&P 500 reported that fell short of analysts’ earnings and 375 businesses exceeded them, according to S&P.

The stocks of Macy’s and Dollar General jumped Thursday after the companies’ executives gave optimism outlooks. “While macroeconomic pressures on consumer spending increased during the quarter, our customers continued to shop,” Macy’s said in a statement. The retail chain increased its profits forecast.

Even Deere and Cisco — two companies that warned about supply chain problems — said there was no drop-off in demand for their products.

Wall Street analysts, generally an optimism lot, remain so now. They have chopped their profit projections for some sectors — companies selling bigger tickets items to consumers and industrial businesses — but increased them for others, energy in particular. Even as economic uncertainty has deepened, the analysts have steadily increased their forecasts for the yearly earnings of all the companies in the S&P 500 and expect earnings to rise 10% this year and next, according to data from FactSet.

But O’Rourke said analysts typically didn’t cut estimates until companies issued public warnings that business was starting to sour. Such warnings might not come in earnest until second-quarter earnings are reported starting in July.

“Analysts in general know the numbers have to come down,” O’Rourke said. “They just want something to base it on.”

For now, many analysts and corporate executives say they are not worried about demand. They say individuals and businesses have plenty of money to buy goods and services — even with higher interest rates.

A recently published survey that the Fed conducted in the fall underlined the dissonance between weak consumer sentiment as measured by the University of Michigan or The Conference Board and solid household bank accounts.

The Fed found that the share of adults who said they had the cash to cover a $400 emergency expense had reached its highest level since the polling question began in 2013 — 68%. Fed officials declined to speculate on high inflation’s effects on this measure.

Worries that spikes in food and fuel costs could force American families to pull drastically back on discretionary purchases have been partly alleviated by recent data. Retail sales climbed to a new high in April, while activity in industrial production also rose to a record level last month.

Even as lower-income households have used up much of their pandemic-era savings, it’s possible that higher earners could help sustain heightened levels of consumer spending. Many people are eager to travel now that the coronavirus pandemic has generally faded as a life-altering concern for many families. United Airlines, Southwest Airlines and JetBlue said this month that their second-quarter revenue would be higher than they had expected.

Morgan Stanley analysts noted that even though lower-income households would be dealing the biggest blow by inflation, they accounted for a small share of consumption in the relative economy. Households in the bottom 60% of income distribution usually account for less than 40% of total expenditures, the analysts found, while the top 40% make up more than 60% of spending.

Jim Paulsen, chief market strategist at the Leuthold Group, said that financial conditions had been tightening for a while and that inflation was likely to moderate soon. That, he said, would make consumers feel better about the economy and give them more purchasing power.

In a market drenched with pessimism, any good news could send stocks higher, Paulsen said. “Our hope has been destroyed,” he said. “And that is a bull market feast. That’s where bears die.”

The S&P 500 closed up 6.6% last week.

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