Not Even a Rate Cut Can Shield Profit Growth From the Headwinds
The market is painting a rosier profit growth picture than it should, so let's dig into what companies are reporting on the ground and my take on a likely quarter-percentage point rate cut.
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Investors continue to believe wholeheartedly in a "soft landing" for the economy, based on trading action last week. Let me show you why I'm not buying that - and why a small rate cut won't like help much.
The S&P 500 is now priced at above 22-times forward earnings. This would be a giddy valuation if the economy were robust, which it clearly isn’t. Currently, analysts are looking for approximately 9% year-over-year adjusted profit growth in the second quarter. But actual profit growth is likely to be in the 10% to 12% range. That would be the best quarter for profit growth since late in 2022. That said, companies face a variety of increasing headwinds for achieving additional profit growth going forward.
Over the past few months, I have been hammering on the weakening consumer theme. All one has to do is to look at recent commentary from the likes of McDonald's MCD, Starbucks SBUX, Home Depot HD and numerous other well-known brand names to know the American consumer is not in good shape. With the personal savings rate near historical lows, credit card debt at record highs and real wages down from where they were three and a half years ago after inflation, it is hard to see how consumer demand improves to any significant extent.
In addition, the commercial real estate sector continues to deteriorate with rising delinquency and default rates. In my email inbox this morning was news that yet another loan against an office building in Los Angeles went into special servicing, this time for the sum of $400 million. Given the increasing distress on the consumer and commercial real estate, it is hardly surprising to see credit loss provisions being hiked up at banks, taking a chunk out of profits. Even mighty JPMorgan Chase & Co. JPM had to increase its provision for credit losses to a more than expected $3.05 billion from $1.88 billion in the previous quarter within its second-quarter numbers that came out last week.
Then there is the large amount of corporate and commercial real estate debt that has be refinanced at much higher rates in the coming quarters at much higher rates. A quarter-percentage point cut or two to the Fed Funds rate only helps marginally here. Take construction giant Tutor Perini TPC. The company saw a surge of operational cash flow in the first quarter for numerous reasons. This helped management in late April retire $500 million worth of debt that was set to mature in 2025, with $400 million of debt that will come due in 2029. All good on the surface. But its old debt had a coupon of just less than 7%. Its new debt will cost Tutor nearly 12% per annum. So even though the amount of debt was reduced by 20%, its annual cost to service these liabilities will rise by nearly 40%, or some $13 million annually.
Given these headwinds, profit growth is likely to be harder to achieve than is currently factored in the market. Especially given the decelerating economy and weakening jobs market.
Futures are now pricing in a near certainty of a cut to the Fed Funds rate at the September federal open market committee meeting. I think they will indeed get a quarter percentage-point cut in two months, but I have my doubts it will help a weakening economy rebound.
The one bright spot: It was good to finally see some sector rotation last week after what has been a historically top-heavy rally here in 2024.
At the time of publication, Jensen had no position in any security mentioned.
