Three headwinds to corporate profit growth

August 15, 2011, 6:22 PM UTC

FORTUNE – In the months following the Great Recession, America’s biggest companies responded to the plunge in consumer demand by slashing costs and cutting workers. Productivity held up and, in tandem, profits soared.

Despite weaker sales and a tepid recovery, profits have continued rising as companies find ways to do more with fewer workers. But while the surge in corporate profits has become one of the few bright spots in an annoyingly weak recovery, experts forecast earnings will slow in the coming quarters.

“It’s going to be tougher for businesses to generate the same kind of profit growth going forward,” says Moody’s Analytics’ economist Mark Zandi. He predicts that profit growth will fall flat in the coming months.

The signs are here already. U.S. stocks – a barometer of corporate profits – have seen sharp swings on worries about the global economy, financial troubles in Europe and the implications of Standard & Poor’s unprecedented downgrade of the United States’ credit rating.

To be sure, corporate profits have been steadily rising since the mid-1980s as companies expanded to overseas markets, benefited from changes in tax laws, among other reasons, says Chris Christopher, economist with Massachusetts-based forecasting firm IHS Global Insight. What’s interesting is how quickly profits grew after the Great Recession. Earnings plummeted during the depths of the downturn to make up just 7% of GDP, but rebounded dramatically during the recovery rising to 12.6% of GDP today – the highest level since the 1950s.

But don’t expect it to last. Here are three headwinds likely to pull down earnings:

Slower economic growth

It has been a slow recovery. And the economy is forecast to grow even slower, adding pressure on consumers who already aren’t spending as much as they used to.

The economy barely grew during the first six months of this year, fanning fears that the U.S. could slip back into anther recession. Goldman Sachs (GS) has lowered its growth projections, with expectations for GDP growth to rise by 2% on average until early 2012 and 2.5% thereafter. Slower growth does not help when there are declines in U.S. productivity, which has helped corporate profits rise dramatically during the economic recovery.

For the past two quarters in a row, productivity, which measures the amount of output per hour worked, has fallen. It dropped 0.3% during the three months ending in June – suggesting that businesses have run out of tools to be more efficient with less workers, according to Paul Dales, economist with Capital Economics. He predicts that productivity will hover around 1%, which would reduce corporate profits.

Falling prices

Steadily falling commodity prices aren’t always bad for companies. Cheaper oil, iron and other materials could help executives secure higher profits, since the costs of resources needed to manufacture products and deliver services is less.

But in a weak economy, price declines could be worrisome. Since consumers aren’t as willing to pay more, companies are forced to draw the line on prices and therefore undergo a squeeze in earnings.

The Federal Reserve has been working vigorously to keep prices stable, and they’ve generally been successful. But in June, for the first time this year, consumer prices fell, largely driven by drops in fuel costs. The latest data from the U.S. Commerce Department show that consumer-price index fell 0.1% in June, following a 0.2% gain in May.

Lower oil prices might sound like good news for consumers, but the underlying reasons are anything but. With debt problems intensifying in Europe and as worries escalate that the U.S. could slip back into a recession, prices have fallen on expectations that the world’s economies are headed for much slower growth.

That effectively reduces demand not only for oil and gasoline but also for things that businesses make and sell.  And the worry is that companies would have to draw the line on prices and therefore see a squeeze in profits.

Rising U.S. Dollar

One of the main drivers of the U.S. economic recovery has been manufacturing. A weaker dollar has helped drive sales abroad, but a stronger dollar could dampen earnings at some companies as it would make goods and services sold abroad more expensive. Zandi says a rise in the greenback could slow profits in the coming months.

Last week, the dollar rose to a four-month high against Australia’s currency and gained versus the euro as investors sought U.S. government debt on worries over debt problems in Europe and as economists widely forecast that world economies could enter a rough patch.

To be sure, the value of the greenback has generally been declining and it might be presumptuous to read too much into recent currency movements. However, some analysts forecast a continued rise in the greenback as Europe’s debt crisis worsens and weaker global growth help stimulate demand for U.S. Treasuries, which in turn help strengthen the U.S. dollar.

Manufacturing orders slumped in July as businesses cut back on orders as demand came in less than expected. The Institute for Supply Management’s factory index fell to 50.9, the lowest since July 2009, from 55.3 a month earlier. Figures less than 50 typical signal a contraction. Manufacturers could rely more on overseas sales, but a stronger dollar certainly wouldn’t help.