US economic recovery is clearly under way. But is it a profitless recovery? Some bears say so. I don’t agree. This year, corporate profits will not rise as much as the consensus forecasts. That’s why I reckon that US Inc and the equity markets will recover at a canter rather than a gallop. But they will still rise sufficiently to support a 10% to 15% rise in equity prices by the year-end.
Recently, there’s been a lot of consternation about the accounting standards used to measure US corporate profits. Enronitis has put the wind up equity markets. But there is a way through the smokescreen of reported corporate earnings results to see what is really happening to business profits in the US.
There are two ways to measure US corporate profits. One is to project company earnings results from the S&P500. But that is fraught with the problems that are now being revealed daily. On this basis, the analyst consensus is forecasting around a 20% rise in reported earnings this year. However, these analysts are underestimating the impact of write-offs and other Enron-style off-balance-sheet liabilities on profits. The forecast write-off by AOL Time-Warner alone is expected to knock $2 to $3 a share – 6% – off the current consensus S&P500 EPS forecast.
A much more reliable method of measuring underlying corporate profit growth is to look at economic profits as provided by the US National Income and Product Accounts (NIPA). This measure looks at profits generated from current production. Critically, this is not distorted by write-offs and other exceptional charges.
Corporate profits depend on two factors: output (revenues) and profit margins (the difference between the price and the cost of a unit of production). In Q3 of 2001, US corporate profits fell 22% year on year. That’s because real corporate output stopped growing (it was up just 2% year on year in nominal terms) and margins collapsed.
Profit margins were 8% in Q3 of 2001, down 3.1 percentage points from a year ago, a much bigger fall than in previous recessions. Margins have been squeezed by rising costs and because corporate pricing power has virtually disappeared. The rise in unit labour costs alone has been a negative drag on profit margins to the tune of four percentage points.
Corporations have not been able to raise prices to accommodate rises in employee nominal compensation rates, which are at record highs. Indeed, for the year to Q3 2001, corporate price increases have failed to cover the cost of rises in unit labour costs – an unprecedented drag on margins.
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In the current environment, raising prices to boost margins seems unlikely. Capacity utilization rates are at 20-year lows and inventories are still relatively high. Corporations are struggling to maintain existing pricing power.
Another factor exerting downward pressure on prices is the strong dollar. I expect the dollar to appreciate 15% against the yen by the year-end. So if the dollar weakens 10% against the euro, as I expect, the US dollar trade-weighted index (TWI) will remain flat. Since domestic prices tend to lag movements in the dollar by around six months, a stable dollar means that US corporations will find it difficult to raise prices by more than 2% in 2002.
Businesses therefore have to focus on cutting costs to lift profit margins. And the key cost is labour.
US Inc has not been lax in trying to do this. Around 1.4 million jobs have been cut since April, not that far behind the rate of downsizing in previous recessions. Job cuts deflate unit labour costs by raising productivity. That’s because aggregate hours worked fall in relation to output. And non-farm productivity growth is recovering. It grew at an annualized 3.5% in Q4 of 2001 – not bad in a recession.
However, because productivity growth is mainly being achieved via a collapse in hours worked, it contributes little to profits because corporate sales volumes are flat. Productivity growth has a low short-term correlation to corporate profits. Statistically, it’s only 30% correlated over the past 20 years. Nominal corporate output and corporate profits are 71% correlated. Just to stop margins from falling, at current compensation and corporate output growth rates, productivity would have to grow by 5.5%, pushing the unemployment rate up to nearly 8% in the process.
So even if productivity growth accelerates through more downsizing, corporate profits are unlikely to prosper unless corporate sales pick up and/or employee compensation growth falls sharply. Businesses will therefore focus on cutting labour costs to lift margins. If we assume that nominal corporate output growth in 2002 of around 3% (1.5% points of real growth and 1.5% of inflation) generates productivity growth of 2%, I estimate employee compensation increases must slow to an annual rate of 2.5% to stop rising labour costs from dragging margins down further.
And for corporate profits to achieve anything like consensus earnings this year, compensation growth must slow to an average 1.5%, from an estimated 3.6% rate in Q4 of 2001. That way, profit margins would rise one percentage point to 9% and corporate profits would grow 15.5% in 2002.
Fortunately, that is just what is likely to happen: for two key reasons. First, in the dynamic new economy of US Inc, corporations have never been more ruthless reducing costs. Downsizing the workforce is just the first step. Bonuses will be cut sharply and hourly pay increases will be slashed.
The second reason is the evolution in the structure of employee compensation in the 1990s.
I reckon that up to 15% of total compensation has been paid in stock options. In 2002, that is going to disappear. The recession and the fall in the stock market mean a reduction in the exercise of stock options as compensation. As a result, we can expect a sharp fall in hourly compensation growth. Indeed, by the middle of 2002, overall compensation will have ceased to grow altogether.
If that happens, unit labour costs will fall in 2002, allowing profit margins to rise. As a result, corporate profits should increase by at least 15% over last year, regardless of whether or not write-offs rise or fall over the course of the year, and regardless of the disease of Enronitis.
That forecast may be less than current consensus estimates. But I reckon these are over-optimistic.
That’s why I project a gradual recovery in corporate profitability and the US equity market, not a V-shaped one. Even so, it would make equities cheap once again when measured against bonds and it’s enough to support 10% to 15% upside in the S&P500 this year.
