In this article, we provide some healthy reminders about the impact of slowing global growth on U.S. profits, payrolls and stock market dynamics. As we illustrate on the following pages, slowing global growth, weighed down by a flat-lining European economy, points to a continued deceleration in S&P 500 earnings growth. In turn, weakening corporate profit trends portend slower payroll growth ahead, which is an environment typically characterized by falling share prices.
Figure 1: Slowing global growth points to decelerating S&P 500 earnings growth
Click to enlarge.
According to the Organisation for Economic Co-operation and Development (OECD), its system of composite leading indicators (CLIs) was developed in the 1970s to give early signals of turning points in economic activity. In figure 1, we showcase the OECD's broadest CLI alongside S&P 500 earnings per share since 1990. The 12-month rate of change on the "OECD + Major Six Non-Member Economies" (NMEs) CLI leads the year-over-year change on S&P 500 trailing 12-month operating EPS by six months. The correlation coefficient is an impressive 0.78, meaning the two series have strong co-movement. The bottom line is slowing global growth points to a continued deceleration in S&P 500 earnings growth.
A few points of detail: The "OECD + Major Six NMEs" CLI covers 39 countries, including Australia, Austria, Belgium, Brazil, Canada, Chile, China, Czech Republic, Denmark, Estonia, Finland, France, Germany, Greece, Hungary, India, Indonesia, Ireland, Israel, Italy, Japan, Korea, Luxembourg, Mexico, Netherlands, New Zealand, Norway, Poland, Portugal, Russian Federation, Slovak Republic, Slovenia, Spain, South Africa, Sweden, Switzerland, Turkey, United Kingdom and United States. As of 2011, the top-five heaviest weights are the U.S. (23.27%), China (17.48%), India (6.91%), Japan (6.79%) and Germany (4.77%). Using the U.S. CLI as a guide, its component series include: Dwellings started, net new orders for durable goods, share prices: NYSE composite, the Thomson Reuters/University of Michigan Consumer Sentiment Index, weekly hours of work: manufacturing, the ISM Manufacturing Index and interest rate spreads.
Figure 2: 25% of S&P 500 sales came from abroad in 2010
The strong link between global growth and U.S. corporate profitability should come as no surprise. Standard & Poor's informs us that, based on a full sample (100%), 24.58% ($2,288,479 million) of S&P 500 companies' global sales (~$8,720,000 million) came from outside of the U.S. in 2010. Based on a truncated sample (15%-85%) of the 255 (51%) S&P 500 companies that fully reported their foreign sales in 2010, 46.29% of global sales came from abroad. Importantly, Europe and Asia represented 29.12% and 13.11% of foreign sales, respectively. The recent weakness of the Markit Flash Manufacturing PMIs for the Eurozone, China, Japan and the U.S. bodes ill for future S&P 500 earnings growth.
Figure 3: Weakening corporate profit trends portend slower payroll growth ahead
In turn, weakening corporate profit trends portend slower payroll growth ahead. In figure 3, we present S&P 500 trailing 12-month operating EPS growth versus total nonfarm payroll growth. Intuitively, there's a close connection between profits and hiring: Accelerating earnings growth leads to a pickup in hiring, just as decelerating earnings growth is followed by less job creation, hiring freezes and layoffs. From our lens, the current divergence between profits and payrolls is unsustainable against a weak global macro backdrop.
Figure 4: An environment of slowing global growth, U.S. profits and payrolls is typically characterized by falling share prices …
What does all of this mean for investors? In short, an environment of slowing global growth, U.S. profits and payrolls is typically characterized by falling share prices. Indeed, figure 4 shows total nonfarm payrolls (year-over-year % change) alongside the S&P 500 (year-over-year % change) since 1990. As you can see, equity returns actually lead payroll growth at major turning points. Clearly, it pays to play defense over offense when global growth, profits and payrolls are slowing.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.