Richard Berner: This Time Fading Earnings Growth is For Real

by: Richard Berner

Excerpt from Morgan Stanley's Chief US Economist Richard Berner's weekly essay:

While I’ve been incorrectly expecting earnings growth to fade for a while, this time it’s for real.

In fact, it’s hardly visible, but the long-awaited slowdown in earnings growth is already underway. Measured in the NIPAs, profit margins dipped slightly (by 20 bp) in the second quarter, after soaring to a record high 14.2% in the winter quarter. So strong were first-half earnings, however, that we now expect that 2006 earnings on a Q4/Q4 basis will rise at a double-digit rate, similar to the 14.4% consensus estimate for S&P 500 operating earnings per share. But in 2007, we expect that profit margins will flatten and earnings will decelerate to a pace below that of nominal GDP — and well below the 9.9% consensus forecast from industry analysts.

Our colleagues in US equity strategy note that their S&P 500 three-month FY2 Earnings Revision Factor [ERF] tells the same deceleration story, falling to 5.5% from 7.0% last week. Notably, 14 of the 24 industry groups experienced a decline in three-month ERF over the past month. Not surprisingly, over the past week, energy and materials made downside contributions to the ERF, adding to the negatives from Pharma & Biotech, Food Beverages & Tobacco, Food & Staples Retailing, Autos, and Banks. Contrariwise, Real Estate, Consumer Services, Diversified Financials, Tech Hardware & Equipment, Media, Transportation, and Software & Services all showed upward revisions.

[...]For a year, I’ve been forecasting an earnings slowdown that has yet to show up. Corporate America’s ability to exploit operating leverage may once again surprise to the upside. This time, however, I think the clock is ticking on earnings that will surprise to the downside.

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