What can stop the march of corporate profits? Earnings in the US have been advancing relentlessly at a clip of 10 per cent or more since the second quarter of 2003. S&P 500 earnings rose 18 per cent in the third quarter. UK profits are growing at the same pace, while European and Japanese profits are rising faster, though their growth has been less prolonged.
Various measures suggest this cannot go on for long. Companies cannot continue to outperform the economy. In the very long term, earnings correlate with economic growth and the world’s developed economies are not growing at anything like a double-digit clip. US gross domestic product, according to figures this week, grew only 2.4 per cent in the third quarter.
For a few years there could be many reasons why companies would do better or worse than their domestic economies. Factors such as globalisation and immigration should also raise earnings. So how far can this profit expansion go?
One limit on profits comes from the age-old battle between capital and labour. Once earnings (aka capitalists) take too high a share of GDP, labour tends to fight back. In this profits expansion, the rich have grown much richer. Profit margins for the US corporate sector, excluding farms and the financial sector, reached 11.8 per cent in the third quarter. David Rosenberg, North American economist at Merrill Lynch, says this is the highest margin companies have taken since 1951.
Another measure shows capital doing better than it has done in half a century. According to Tim Lee of pi Economics in Connecticut, post-tax profits have reached 8.5 per cent of GDP. This is the highest profit share for companies since the second world war and compares with a post-war profit average of 5.9 per cent.
What are the mechanisms for bringing this profit share down? Primarily, it is linked to the economic cycle: when times are good, employment is full and workers’ bargaining power is higher. Ben Bernanke, the chairman of the Federal Reserve, warned this week of the dangers of wage inflation. Many analysts were making the same point: the profit share looked high, companies’ unit labour costs were rising and a correction looked likely.
Then came this week’s revisions of US growth data, showing that pressure from the US labour market was declining. Unit labour costs were falling 2.8 per cent year on year into the second quarter – the biggest such drop in 23 years, according to Mr Rosenberg. However, the negotiating power of labour is not rising.
This revision was enough to convert some bears to optimism. Tim Bond, head of asset allocation at Barclays Capital in London, said the revision had “largely removed what had previously appeared to be a clouding outlook for corporate profits”, and that forecasts of a 10 per cent increase in S&P 500 profits for next year now seemed “appropriate”.
What other limits are there on earnings growth? One comes from basic company finances. Earnings per share – which should drive equity valuations – have boomed since the bear market reached a trough in 2002. It has done so much more than other measures of profitability. The S&P 500 and the FTSE Eurofirst 300 demonstrate much the same pattern. Earnings before interest, tax, depreciation and amortisation (ebitda), a favoured measure of profitability, have increased by about 40 per cent since hitting the bottom in 2002; EPS have more than quadrupled.
EPS can be raised by using cash to retire shares. This is a particularly easy game to play in Europe, thanks to cheap debt. They can also be raised by cutting interest costs through retiring debt or by renegotiating it at a lower rate.
Neither action will affect ebitda. The disparity between EPS and ebitda demonstrates how much the rally in earnings owes to cheap debt and to companies’ zeal to clean up their balance sheets.
Such financial engineering cannot continue indefinitely. But as the wave of debt-funded takeovers shows, no end is in sight. The risk would be a rise in interest rates, which is currently not foreseen by the credit markets.
Other limitations come from the business cycle. Companies tend to overshoot: investing too much and letting inventories get too big when times are good, then cutting back too much in tough times. This is one reason why profits tend to be geared to the economy, rising as a proportion of GDP during booms and falling during recessions.
Inventories have grown too high, an unhealthy sign. UBS calculates that rising inventories added as much as 0.5 per cent to the GDP of G7 industrialised nations in the third quarter. This could be a symptom that companies are overestimating demand.
But one other line in balance sheets looks healthy – there is a lot of cash. Eight per cent of the market value of S&P 500 companies (excluding the financial sector) comes from cash balances. This is near a 20-year high, according to Tobias Levkovich, US equity strategist at Citigroup. Such cash balances give companies a cushion and suggest they are not overinvesting.
So how long can the profits boom continue? Several of the factors that have boosted earnings can be expected to tail off, but none suggests that a sharp decline is imminent. So we are left where we started. The biggest risk to corporate profits is an economic downturn. If that can be avoided, profits look in good shape.