Caterpillar’s ‘Earnings Recession’ Points to More Bad News for World Economy

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(Bloomberg) — A bellwether of the global industrial economy may be sending out distress signals.

Caterpillar Inc. (NYSE:) is heading for a “mild earnings recession,’’ according to Morgan Stanley (NYSE:), and analysts expect the heavy-equipment maker to post its first year-over-year decline in quarterly profit since 2016 when it reports results on Wednesday.

Margins are shrinking as demand cools and the U.S.-China trade war fuels caution among customers. Machine sales have slipped in Asia and the U.S. on weaker orders in construction industries, just as the Deerfield, Illinois-based company has been trying to raise prices. That helps explain why analysts have pared the earnings outlook five times since August.

The following charts show why Caterpillar’s earnings report could bring more bad news for the world economy.

Machinery Meter

In June, worldwide machinery sales for Caterpillar grew at the slowest pace in more than two years on a 3-month rolling, year-over-year basis. The company posted the same increase in July and August. The sluggishness is largely due to a slowdown in North America, its largest market, and declining market share in China. Sales in North America expanded at the weakest rate in almost two years in August, and in Asia contracted the most since 2016.

Last week, the International Monetary Fund made a fifth straight cut to its 2019 global growth forecast, citing a broad deceleration across the world’s largest economies as trade tensions undermine the expansion. The forecast for this year would be the weakest since 2009, when the world economy shrank.

Lots on Dealer Lots

With concern over the sales outlook, the amount of equipment available on sellers’ lots has been in the spotlight all year. The company said in July that dealer machine and engine inventories increased about $500 million in the three months through June, compared with an increase of about $100 million in the same period a year earlier. It’s been counting on dealers working through the buildup to help meet 2019 profit targets. But analysts at William Blair & Co., who pared their earnings forecast on Oct. 7, said dealer inventories are instead rising and more production cuts may be needed.

Caterpillar isn’t alone. Manufacturers of durable goods in the U.S. had enough inventory to last 1.69 months in August, the longest since November 2016, according to the Census Bureau.

Stock Figures

Concern over the economic outlook and its impact on demand is showing up in analysts’ share-price targets. The rolling 12-month forecast for Caterpillar’s stock is down about 18% from the same time a year ago. Goldman Sachs Group Inc (NYSE:). trimmed its 2019-2021 earnings per share estimates by 4% on average. The bank said it expects earnings before interest and taxes to decline year-over-year in 2020, driven by “meaningful production cuts in North America and China construction equipment, while mining demand remains tepid given widespread macro uncertainty.”

The stock-price outlook could get help from a resolution in the trade war and further cuts in interest rates among central banks, Larry De Maria, an analyst at William Blair, said in his report earlier this month. But the uncertainty going into a U.S. election year, generally weaker industrial economy, and cyclical construction equipment markets should ultimately override those potential positives, limiting upside, he said.

Softening the Blow

To be sure, there are bright spots for Caterpillar. Earnings are still forecast to reach a record this year, and much of the bad news may already be reflected in the share price. The stock has risen about 4% in 2019, trailing the 15% gain in the . Also, mining-equipment demand has held up, and should help soften the blow from a slowdown in construction, according to Karen Ubelhart, an analyst at Bloomberg Intelligence.

“Mining equipment should lead segment growth, yet is only 15-20% of sales and earnings,” Ubelhart said in a note last week. When Caterpillar reports earnings, “commentary on China will remain a focus, as will significant deceleration in North American construction equipment demand. ”