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When costs go up and revenue growth slows, it is awfully hard to produce decent profit increases. Except, it seems, in corporate America. Reported third quarter earnings for the S&P 500 have increased by 20 per cent year on year in the current results season.
That is impressive – and a little odd. As Ben Bernanke pointed out the other day, rosy assessments of US economic prospects rely heavily on narrower profit margins keeping a lid on inflation. Statistical quirks partly explain the limited earnings erosion so far. As Wednesday’s preliminary gross domestic product numbers showed, profits as a share of GDP remain near record levels. The latest increase, however, appears largely because high corporate investment has yet to feed into the equivalent of depreciation costs, known as capital consumption adjustments.
Similarly, a rebound in profits by insurers after last year’s hurricanes can explain about a third of the jump in earnings for the S&P 500. Share buybacks helped – at least a little. As Standard and Poor’s points out, they actually appear to be doing more than just offsetting new issuance. Still, the record gross $431bn spent on buy-backs in the past 12 months amounts to about 3.3 per cent of the S&P 500’s market capitalisation.
Meanwhile, unit labour costs in non-farm businesses were up 5.3 per cent year on year for the third quarter at the latest count. Stock options being exercised appear partly to blame. But other costs, from many raw materials to interest rates, are also up from last year, just as productivity growth has waned.
Companies appear to have little scope to pass on those higher costs to consumers. Instead, October producer prices for finished goods excluding food and energy were up just 0.6 per cent year on year. With revenue growth slowing, it is no wonder the bulk of outlook statements issued have been below consensus expectations. What is more surprising is that investors should be pencilling in earnings per share growth close to 10 per cent going forward. They should keep in mind that profits – like share prices – can go down as well as up.