A far more hostile outlook for US corporate profits

However, in the last nine years, corporate profit growth accelerated, this particularly for S&P 500 companies. Thus, in the last nine years, S&P 500 operating earnings have grown by 13.5% per year, compared to 5.8% growth in GDP; the highest annual earnings growth rate over a nine years period since the Second World War. But how sustainable is this extraordinary earnings growth period?

Among economists there is agreement that, in the 1990s, American corporations did benefit from a number of very favorable conditions, which boosted their profit margins and net earnings.

Declining interest rates lowered financing costs and benign labour cost increases brought unit labour costs down. In addition, companies did benefit from lower corporate tax rates and declining commodity prices. The capital spending boom of the late 1990s also played a role in the above trend-line growth for profits.

This was so, because when capital expenditures rise rapidly, sales of capital goods are recorded as revenues and profits to the suppliers, but are depreciated over a number of years by the buyers. Therefore, a front-loading of earnings does take place in every capital-spending boom.

There were also some other factors, which did greatly benefit US corporate profits. When in the late 1980s, the communistic and socialistic doctrine broke down, the economic sphere of the world increased hugely, with population rich countries with unsaturated markets opening their markets for business to the multinational corporations.

To these multinationals the world truly became their oyster, since in the newly opened markets there were hardly any companies that could challenge their rapid market share expansion. The multinationals had an edge because of their superior products, knowledge, management techniques, marketing skills and their access to cheap capital. Hence the 'globalization' trend was particularly favorable for the multinationals in the 1990s, that is, until the Asian crisis.

Then, there is another point to consider. In the 1990s, outsourcing became the name of the game. By closing down their own production facilities, many companies shifted their production to low cost contract manufacturers south of the border and to Asia. As a result costs declined, while in the home market a declining saving rate and the wealth effect, due to rapidly rising equity prices, buoyed consumption

Rapidly appreciating equity prices also boosted corporate profits artificially through 'investment gains', stock buy backs financed with debt issuance (increased leverage), and the surpluses of pension funds, which, when over-funded, allowed companies to book these as profits.

The 'virtuous corporate profit expansion' of the 1990s will, however, be followed by a vicious secular downswing in profits for the following reasons. It is true that short-term interest rates may continue to decline, but only if the economy stays weak and if commodity prices remain depressed.

Also, lower short-term rates may not benefit the corporate sector much since capital costs have been rising because of widening yield spreads and declining stock prices. In addition, it is possible for short-term rates to decline while long term rates, which depend largely on inflationary expectations, remain steady or even rise.

Commodity prices, which have been in more than a 20-year bear market are also showing signs of bottoming out. The tripling of oil prices over the last two years is a warning shot, that the down-cycle for commodities and interest rates with their beneficial impact on corporate profits may have run their course. Then, there is the stock market, which is unlikely to appreciate as much in the next few years as in the late 1990s.

Compensation costs, which were kept down artificially through generous option packages, could, therefore, rise more than is expected, as employees become more interested in salary increases than potential capital gains on stock options. A sideward move or, as I think, a declining move in stock prices will also deprive the consumer from recurring capital gains. Thus, the saving rate will not plunge any further, as it did in the late 1990s, and fuel consumption growth.

In fact, if stocks no longer rise, or decline more, the saving rate will inevitably rise again and reduce consumption growth. At the same time, the recent decline in stock prices will cut capital spending, since capital spending is closely correlated to stock prices. Declining or sideward moving stock prices will also erase investment gains and in many cases turn them into investment losses.

Finally, the US corporate sector has now the highest debt burden as a percentage of revenues ever. In a sluggish and possibly deflationary environment this will, along with rising depreciation charges, wreck havoc with profits. But worse is to come from overseas.

Outsourcing was great as a cost reduction measure. But it always entailed a serious longer-term danger as valuable technology was transferred. In time, contract manufacturers in Asia, whose margins are razor thin, will build their own brands in order to improve their margins. They will then compete fiercely with the very multinational they were so far supplying.

This is an inevitable trend, in my opinion. Also, in the early 1990s, the multinationals faced little competition from local companies in countries like China and Russia, because local companies were poorly run and sold products of inferior quality. But, over the last few years, local companies have grown up and become far more competitive and are taking market share away from the multinationals.

Lastly, the anti-globalization protesters are a symptom of growing tensions between the developing world and the rich nations of the west. A revolution is underway whose objective is not to send the aristocracy to the guillotine, but which aims to shake up the rich nations' economic hegemony.

This new geopolitical and economic environment will be characterized by increased pressures on patent laws and royalty payments, an unwillingness to repay foreign debt obligations and anti-western propaganda, since it is easy for incompetent governments to blame all that went wrong on foreign capitalists.

In sum, this is hardly a global macroeconomic environment that could offset structural profit weakness in the US domestic market. So what should an investor do who wants, or must have, an exposure to equities?

After years of an incredible under-performance, Asian and the Russian stock markets have recently begun to out-perform the US stock market. And whereas, the US is likely to continue to suffer from a profit deflation and badly disappoint investors who are still far too optimistic about future corporate earnings' growth, corporate profits in the emerging market universe are at the trough of a cycle.

So I recommend, for investors who can't stand cash or are heavily weighted in US equities to gradually shift their exposure away from the US multinationals to local companies in emerging markets.