The latest earnings season produced a significant number of profit beats but also a noticeable drop in revenues suggesting sluggish demand and with the elevated share buybacks some say that this scenario is suggestive of a so-called Japanese Trap.
“Of the 119 companies that have reported earnings thus far, 68% have beat estimates, higher than the historical norm of 62%. While this may seem positive, it’s important to note that only 42% of companies are beating revenue estimates, causing investors to question the health of U.S. corporations,” says S&P in its latest report.
“The current earnings surprise ratio stands at a positive 6.4%, higher than the 10-year average of only 3%. On the other hand, companies are actually missing revenue estimates by an average of 0.4%,” notes S&P.
These earnings gains, says S&P, are a result of corporations being still able to find places where they can cut their expenses – an occurrence which is deemed to be finite.
S&P also says that many of the earning beats are a result of “implementing clever but unsustainable accounting methods.”
One therefore presumes that at some point corporations will no longer be able to find things to cut while, at the same time, exhaust the “creative” accounting that inflates their earnings.
At the same time, corporate buybacks are on an upward momentum which results in a net decrease in equity.
Sluggish demand (left chart) and anemic business investment (chart on right)
In a recent note, Natixis puts these 3 developments – rising earnings and buy backs against weakening corporate revenue – and suggests to their clients that these are the symptoms of a Japanese trap.
“By consequence, the components of the “Japanese trap” are taking shape: profits are not invested, waged income is weak, and corporate savings are used inefficiently (deleveraging in the euro zone and in the United Kingdom; share buybacks in the United States; increase in financial assets held). Can we already see signs that potential growth is weakening in these countries? The answer is undoubtedly yes,” says Natixis report.
Increase in corporate buybacks is reflected in a negative net equity issuance as percent of GDP (left chart) which, as an investment, does nothing to increase productivity (chart on right)
They say that the flat to decreasing consumer demand will shrink corporate revenue over time (chart 7B) which will flatten the business investment as percent of GDP (chart 8A) while savings (corporate profits) would increasingly go into removing equity shares out of the market (chart 9B) as labor productivity sinks (9D).
“Therefore, we have excessively high corporate savings, weak domestic demand overall, reduction in potential growth due to the decline in the investment rate and the inefficient utilisation of savings. We fear that the Japanese trap, pulling out from which is difficult, is also under way in the United States, the euro zone (apart from France where profitability is poor) and the United Kingdom,” concludes Natixis.