A fair share
Aug 27th 2009
From The Economist print edition
Has the tide turned for corporate profits?
Illustration by S. Kambayashi
THE equity bull market had many foundations, including low interest rates and steady global growth. But the strength of corporate profits was a vital component; in 2006 American profits achieved their highest share of GDP since the second world war.
The recent rally in shares has been driven by the low yields available on alternative asset classes like cash and government bonds and by hopes of economic recovery. But if those recovery hopes do not translate into a rebound in profits, it is hard to see how the rally can last.
The American second-quarter results season was undoubtedly better than expected. But it is worth remembering that such positive surprises are quite common, with companies massaging down expectations in the run-up to their figures. David Rosenberg of Gluskin Sheff, a Canadian asset-management firm, says profits were actually down 27.8% year-on-year; analysts are still expecting a 20.6% annual fall in the third quarter having thought there would be a 2.6% rise as recently as the start of the year.
With profits still falling, the rally has thus been driven by a re-rating of the market. Assuming operating earnings hit $50 a share in the third quarter, the S&P 500 index is trading on a price-earnings ratio of 20, the kind of multiple normally associated with boom conditions. Clearly, investors are expecting a robust profits recovery in the years ahead.
But companies are digging themselves out of a deep pit. In terms of operating earnings, the best calendar year for the S&P 500 was 2006, when profits reached $88 a share. According to Citigroup, which has just raised its forecasts, earnings will not regain that level until 2013. The current era rather resembles the biblical dream of seven lean years.
Tim Lee of pi Economics reckons that American profits may be depressed for some time, because the country is headed for a prolonged period of slow growth. This argument depends on a number of assumptions. Is America headed for slow growth and, if so, why? One reason could be a demographic shift, with baby boomers dropping out of the workforce; if labour becomes more scarce, real wages will rise, at the expense of profit margins.
However, other nations are in a worse demographic position. In addition, the conventional explanation for the high share of profits in 2006 was the downward pressure on wages arising from the growing Chinese manufacturing labour force, a factor that is unlikely to disappear soon.
Mr Lee argues instead that America’s slow growth will be the consequence of its terrible savings rate—on the grounds that America cannot borrow from abroad to fund its investment for ever, and investment drives the growth rate. The link sounds plausible: take China’s regular 9-10% annual growth and its high savings rate. But the relationship is far from automatic. Japan had a high savings rate for years but has suffered dismal growth over the past two decades.
In the short term, a simpler explanation may be that a low savings rate has left American consumers with a heavy debt burden. As consumers try to pay down those debts, the result will be sluggish demand and thus slower growth.
Would that necessarily mean a smaller share for profits within GDP? Mr Lee says slower growth implies a lower return on assets and thus subdued profits. Indeed, a casual look at the ratio of corporate profits to net assets since the early 1950s shows two peaks: in the mid-1960s and late-1990s, both periods of robust growth. The lows for the ratio came in the stagflationary 1970s.
An obvious explanation for the relationship is operational gearing; companies need a certain level of sales to cover their fixed costs and once that level is reached, margins rise substantially. In a slow-growing economy, that critical level will be reached by fewer firms (although eventually companies will cut their costs to suit the new conditions).
Financial gearing may be another reason. During the boom, companies had access to cheap credit, which increased the number of profitable projects they could fund. The crunch has made banks less able to lend and companies less willing to borrow, at least for a few years.
The details of Mr Lee’s arguments are certainly open to challenge. But he may still have got the direction of change right. After the last profit-share peak in the mid-1960s, the corporate sector suffered a long and dismal decline. A world marked by greater regulation and higher taxes is unlikely to be good for profits.
Copyright © 2009 The Economist Newspaper and The Economist Group. All rights reserved.
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