A far more hostile outlook for US corporate profits (page 1 of 2)

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.