The chickens are coming home to roost. After a remarkable eight-month rally in the dollar, many U.S. firms are finally feeling the pinch.

In the near-term, investors need to brace for a cautious earnings season. Yet, as I’ll explain in a moment, there are still ample reasons for long-term optimism, especially when the dollar loses momentum and/or the global economy starts to rebound in earnest.

The strong dollar, which blunts the competitiveness of American firms, both at home and abroad, will have a clear impact on first-quarter results and forward outlooks. According to FactSet Research, 85 companies in the S&P 500 have already warned of a Q1 profit shortfall, while just 16 companies have pre-announced that results will be better than expected. If that figure of 16 holds, it will be the lowest number since the first quarter of 2006.

While much has been made of the dimming profit picture for energy companies, the pain is also building for industrial firms, many of which have global sales exposure. You can see the growing headwinds for this sector by glancing at the recent monthly reports from the Institute of Supply Management. 

Is The Manufacturing Sector Headed for Contraction?

 

The most recent reading of 51.5 for this index was the lowest in nearly two years. A move below 50 in this gauge signals a contraction in manufacturing.

While it may be easy to conclude that the industrial economy typically slows in the first quarter, as was the case in 2014, this time may be different. There are now multiple headwinds in place: reduced equipment demand from energy companies that cut spending, a still-slow global economy and excess inventory levels that need to be whittled down.  

The initial slump in the energy sector, followed by the emerging slump in the broader industrial sector, would be concerning enough. But the consumer end of the economy is hardly the picture of health either. An improving employment picture still has not led to a spending upturn on apparel, housing and other key categories. There are even growing concerns that the auto industry may be approaching a cyclical peak.

Conference calls begin on Wednesday, April 7, with Alcoa, Inc.’s (NYSE: AA) Q1 report. Here’s what I’ll be listening for:

As demand slows, will companies resort to layoffs?
Few investors may know about Worthington Industries, Inc. (NYSE: WOR), but the company is something of a “canary in the coalmine” for the industrial sector, as it makes a range of engineered components for a broad variety of customers.

#-ad_banner-#In the face of slowing demand, Worthington’s management recently announced plans to close a factory that employed more than 500 people. Companies only take that step when they think a slump will be prolonged.

The question: will other companies follow suit and announce layoffs in coming weeks? That would dampen investor psychology, as expectations of firming employment have helped propel the major stock market indexes to new heights in recent months. Said another way, expectations that the U.S. economy can grow at a nearly 3% pace this year will be dashed if companies start to speak of an extended weakness.

Keep repurchasing shares?
Companies have gotten in the habit of pairing bad news with good news. Whenever management issues a sobering outlook and shares may take a hit, they have often sought to announce new or bigger share buyback plans.

Will that be the case again in coming weeks? If so, then the fallout from a tough earnings season may be limited.

It’s important to remember that companies in the S&P 500 (outside of financials) have a record $1.43 trillion in cash, according to Factset Research. And since most companies are already quite lean — with impressive operating margins to prove it — a slowing economy is not expected to lead to outright losses at most firms. As long as cash flow stays positive, then there won’t be any sort of panic.

What about M&A?
With so much cash on hand and the dollar currently on steroids, it’s fair to ask why more companies aren’t going on a global shopping spree. The answer may lie with the fact that stock prices in Europe, China and Japan are also elevated, and few bargains may be available.

Still, for companies that are facing a material slowdown in growth, deal-making activity could expand. The tech sector appears especially ripe. Of the 10 companies in the S&P 500 with the largest cash balances, five of them are tech stocks (led by Microsoft Corp. (Nasdaq: MSFT), with roughly $100 billion in cash).

How will the Fed impact earnings?
If Q1 results and outlooks are indeed as sobering as recent economic reports predict, then the chances that the Fed will start to raise interest rates in June will rapidly diminish. Of course a pushed-out Fed date has created a continually positive backdrop for stocks, but how long will investors see this glass as half-full? After all, low rates, resulting from economic weakness, can be seen by some as a harbinger of a recession.

Few are using the “R” word right now, but as I wrote in 2013, the yield curve is an important item for investors to track. When I wrote that, the yield in the 10-Year Treasury was making a fast move toward the 3% mark. These days, that economic bellwether is looking much more subdued.

Risks To Consider: As an upside risk, the labor force continues to grow, which could offset the drag created by slumping export markets.

Action To Take–> In the face of clear economic headwinds, the stock market’s resilience is quite impressive. Yet this is no time for complacency. The impending earnings season will likely reveal that demand trends remain weak and that U.S. corporate profits are unlikely to grow very much this year. The key for investors is to focus on sectors showing strength, and avoid sectors showing weakness. You can glean a lot about the economy and corporate sales trends by carving out time for the upcoming set of conference calls.

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