The Dark Side of Strong Corporate Earnings

The Dark Side of Strong Corporate Earnings

By KELLY EVANS

A climbing stock market and strong corporate earnings aren't quite the beacons of light they once were for the U.S. economy.

.The first-quarter earnings season kicks off Monday, and it looks to be another impressive one. The number of profit-warning announcements over the past three months is near a decade low, according to brokerage firm Brockhouse Cooper. Analysts expect S&P 500 earnings to rise 12% from a year ago, and that may prove conservative.

A strong earnings season could push the S&P 500-stock index to three-year highs in the 1350-to-1400 range, reckons Bank of America Merrill Lynch strategist David Bianco. Typically, stock-market gains are one of the most bullish leading indicators, and yet economists are marking U.S. growth figures down. First-quarter real gross domestic product looks to have expanded at only about a 2% annualized pace, even with the Obama payroll tax cut and the Federal Reserve's $600 billion quantitative-easing program in place.

Growth may firm up later this year. But the relative weakness with each quarter raises a question: Why isn't the U.S. economy accelerating, especially with the corporate sector in such good shape?

Perhaps because corporate earnings aren't being driven by strength in the U.S., but to some degree by its weakness. Companies have shifted production and sourcing overseas to cut costs and to tap demand in faster expanding markets. Capital spending in emerging markets like China and India has more than doubled in the past decade, and surpassed developed markets last year for the first time, HSBC estimates.

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The first-quarter earnings season kicks off Monday, and it looks to be another impressive one. The number of profit-warning announcements over the past three months is near a decade low.
.That is fostering growth abroad but undercutting prospects in the U.S. The nation's factors of production, such as factories and equipment, or capital stock, actually shrank in 2009 for the first time in postwar history. Business investment did rebound last year, but the 15% increase, which should have generated 380,000 jobs on average a month, created only 78,000, notes UniCredit economist Harm Bandholz. The rebound appears largely to have been maintenance-driven, and investment has leveled off since.

The shifting of investment overseas and erosion of the nation's capital stock are no small matter. They imply a lower potential growth rate for the U.S. and higher structural unemployment. As that reality dawns, the corporate sector's strength may start to lose its luster.

Write to Kelly Evans at kelly.evans@wsj.com