June 3rd, 2011 | By Nick Sargen
Through the first five months of this year, news on the economic front has been disappointing, as the U.S. economy grew by less than a 2% rate in the first quarter, and economists have been paring back estimates for growth in the current quarter to 2%-3%.
Despite this, the U.S. stock market has proved to be resilient, mainly because the corporate sector has continued to deliver stronger-than-expected earnings. Nonetheless, many observers question how long this situation can last.
In this regard, I have found two recent reports, one by Bank Credit Analyst (BCA) and the other by J.P. Morgan Economics, to be very helpful.1 Both reports arrive at a similar conclusion about the reason U.S. profits have been so strong: The “V-shaped” recovery in profits primarily reflects a dramatic rebound in domestic financial sector profits and an unprecedented increase in overseas profits of U.S. companies. Looking ahead, both studies identify factors that are likely to limit the increase in profit margins; consequently, future profit growth is likely to be tied more closely to the economy.
The reports by BCA and J.P. Morgan both examine the three main segments of U.S. corporate profits, and arrive at similar conclusions:
Based on these considerations, both BCA and Morgan’s economists believe the period of profit margin expansion is coming to an end. By the same token, they are not overly concerned about a squeeze in margins anytime soon.
BCA concludes its assessment as follows:
“Putting this all together, the implication is that it will be extremely hard for margins to rise further from current levels. Yet, the trend in margins tends to follow the economic cycle, so it would be unusual for margins to weaken sharply in the absence of a marked slowdown in the pace of economic growth.”
BCA’s equity forecast calls for overall earnings per share to sustain growth of about 4% until the next recession. Assuming no change in market multiples, this would imply annualized equity returns of about 6% in the next few years.
Morgan’s economists forecast is a bit more optimistic. They believe there is room for some gradual improvement in profit margins, with output growth expected to exceed growth in unit labor costs. Their call is that real GDP growth will average 3% in the next few years, which they believe is consistent with 10% annual profit gains through 2013.
My take is that both analyses offer reassurance that the huge rebound in the U.S. equity market over the past two years is grounded in broad-based profit growth, and that the stock market can continue to advance, albeit more gradually and with greater volatility, than in the past two years. At the same time, investors must be cognizant of risks that could derail this benign forecast. On this score, BCA and Morgan’s reports highlight the disparity between strong profit growth and weak growth in labor income.
From Morgan’s economists’ perspective one of the principal risks to the outlook is that a tightening of fiscal policy could dampen economic growth and household income gains in the next few years. Indeed, they believe fiscal stimulus played a critical role in redistributing income at a time of extensive corporate cost cutting:
“Corporations moved aggressively to shed labor costs as the recession took hold and continued their aggressive cost cutting through the early stages of the expansion…This strategy would normally prove self-defeating to companies trying to expand their margins as stagnant labor income would tend to stifle consumer spending and the nascent economic recovery. However, household spending over the past three years was buoyed by public policy that provided enormous income supports, as reflected in the nearly 9%-pt of GDP rise in the US government budget deficit.”
The BCA report also notes the huge disparity between the stellar performance of the corporate sector and the tough environment for workers and families: “While real domestic corporate profits have climbed by more than 200% since the beginning of 1990, real compensation for corporate employees has risen by a mere 20%, while real median family incomes increased by only 2%.” The report concludes the health of the corporate sector ultimately depends on the financial health of its customers, and that the divergence between rising profits and weak growth in consumer incomes will have to change.
How this will play out remains to be seen. BCA posits two potential outcomes. The optimistic view is that the corporate sector’s healthy financial position will eventually lead to stronger growth in employment and household incomes. The more negative view is that companies are more interested in expanding overseas operations than in boosting domestic hiring and investment.
My own perspective is that recent employment reports offers some encouragement that businesses are beginning to hire again, which bodes well for the sustainability of the recovery. But it is too early to be confident that jobs growth is returning to normal, in which monthly nonfarm payrolls expand by 250,000 to 300,000 workers. Until there is clearer evidence that job growth is normalizing, I believe the stock market’s recent choppy performance will continue for a while longer.
1 BCA, “High Profit Margins and Stagnant Real Incomes: Is Capitalism Working Properly/?” May 24, 2011. J.P. Morgan Economics, “The US Profit upturn to survive the shift toward fiscal tightening,” May 20, 2011.