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Weak Global Economy May Dampen Corporate Earnings

Although the U.S. economy should continue to grow in the coming year, a weaker global economy could impact corporate earnings, says Morningstar's Bob Johnson.

Weak Global Economy May Dampen Corporate Earnings

Jeremy Glaser: For Morningstar, I'm Jeremy Glaser. The IMF downgraded its global growth forecast this week, sending markets tumbling. I'm joined by Bob Johnson--he's our director of economic analysis--for his take.

Bob, thanks for joining me.

Bob Johnson: Thanks for having me today.

Glaser: Let's take a look at that report. What did the IMF downgrade and what was driving it?

Johnson: They basically do the growth rates across multiple countries and regions. So, it's one of the most comprehensive reports, and they do this a few times every year. It's usually highly looked at and often market-moving, as it was on Tuesday when it caused a dramatic decline in the world stock markets.

Inside those numbers: Basically, they took 2014 growth rates and reduced them from 3.4% to 3.3%. Those are inflation-adjusted GDP numbers. That sounds kind of OK until you think, "Well, but the 3.3% was the same as it was in 2013." So much for an accelerating world economy in 2014 helping out everybody; it's really been relatively flat. Then, they also pulled in the numbers for 2015. They had been hoping for a pretty big jump to 4% growth in GDP in 2015 and, instead, they've now reduced that to 3.8%. So, kind of a relatively important downgrade.

Glaser: What were the biggest drivers of it?

Johnson: If you looked at individual countries and, again, it depends by year, but for the 2014 forecast we had a 1% reduction from Brazil, a 0.7% of a reduction from Japan; but that was offset by of a 0.5% increase in the U.S. growth rate. So, those were the major drivers in this year's forecast. Then looking to 2015--and, of course, there were some bigger changes--Brazil was down 0.6%, Russia down 0.5%, Japan down 0.2%. So, it certainly was not a particularly good number for 2015.

Glaser: For U.S.-based investors, though, if the U.S. looks like it might be doing even a little bit better than they expected, should they care about this report? Does it have a major impact?

Johnson: For a lot of reasons, the U.S. is a little bit more isolated in the world economy than most, but [the world economy is] still a lot more important than it used to be. The U.S. has 13% of their economy from exports. That number 50 or 60 years ago used be as low as 5%. So, clearly, it's more important than it used to be. On the other hand, unlike most other developed countries, the export number is more like 25% to 35% of GDP. So, clearly, the world stage is not as important to the U.S. as it is to many other players in the world.

Glaser: Other than exports, what are some of the big impacts going to be? How are central banks going to react to a slower-growing world?

Johnson: I think that's where you're going to see the bigger impact. And we've already seen that in the U.S., and some of it actually is helpful. The U.S. has been tightening central bank policy. They've stopped buying back some of the bonds that they were [purchasing] and are now even talking potentially a rate increase down the road. Certainly, some of the other economies, because they're weaker, there are people clamoring for more central bank action in the months and years ahead. And we've already seen those people loosen their monetary policy, and that's brought down interest rates in Europe and other places. That has also forced U.S. interest rates down as well.

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So, certainly, it's had a big impact there. And while we had all thought [the U.S. Fed included] that interest rates in the U.S., because of the central bank action, would be much higher by now, actions by other central banks because slow growth have held back interest rates more than anybody would have guessed.

The second thing that's really a big impact is on the U.S. dollar. Certainly, with those higher rates, there's going to be a bigger demand for dollars. And what does that mean? That means a higher price for the dollar. And that can be good and bad news. It keeps down inflation in the U.S. (which is the good news), but it also makes some goods less competitive in overseas markets. And then also with the slower world growth rate--especially in China, which is very resource-intensive--slower growth rates will also tend to push down commodity prices. In fact, one might argue that falling commodity prices might have a more positive impact and a greater impact on the U.S. economy than the effect of slower growth in, say, China and in Europe.

Glaser: Stock market investors are particularly interested in corporate earnings. That really is driving returns there. What impact do you think a slower-growing world but a still reasonably fast-growing U.S. will have on U.S. corporate earnings?

Johnson: I think that's a very interesting question. We had a pretty big disconnect between 2010-12 when the U.S. economy was very slow at coming back--especially on the jobs front--but corporate earnings absolutely soared. That's because of an increasing amount of profits from even U.S. multinationals and outcomes from overseas. It's a huge percentage, and much of the goods produced for overseas markets are produced in overseas countries. It doesn't benefit the U.S. So, we saw soaring corporate earnings in 2010-12, but the U.S. economy not so much.

Now, we are going to have a little bit of the reverse, where I think the U.S. economy is going to do just fine, thank you--and I think we are going to have better growth than most people expected. But meanwhile, corporate earnings are going to be impacted by many of the weaker world growth situations. You've got weaker growth overall. So, if 40% of your sales are overseas and that's slowing, that's certainly not a good thing.

Then, we've got the dollar impact that I talked about, and that's got a two-way impact. One: Just the pure, mechanical translating back into dollars from foreign currencies. When the dollar is stronger, that means less foreign dollars is reported in the U.S. I expect, even in this set of quarterly earnings reports, we're going to see more companies complaining about, "Well, if you take out the currency effects, we did really well, but not so good with [those effects]." So, I think that's one thing that we're going to be hearing more about--if not this quarter, then certainly next quarter with the dollar being quite a bit stronger.

And then over time, it takes a little bit longer to adjust with the dollar being stronger. That means, without adjustments, the U.S. prices for goods are going to go up. And that means we are going to be less competitive versus, say, a Germany or a Japan--whose currencies are now weaker and they are now more competitive than they used to be. So, that will also have an impact on U.S. corporations.

Glaser: Bob, I certainly appreciate your take on global growth today.

Johnson: Thank you.

Glaser: For Morningstar, I'm Jeremy Glaser. Thanks for watching.

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