It’s not just wages that have been squeezed in the last few years. Profits have been too. A recent report from accountants EY showed that the number of profit warnings has risen to a three year high, and official figures show that total profits, after inflation, are still 9.7 per cent lower than they were at their pre-recession peak in 2007. This poses the question: why is this, and what might change?
Here’s a framework which I find helpful for thinking about such questions. It’s a simple rearrangement of national accounts identities. GDP is equal to the sum of incomes: wages (W), profits (P), taxes (T) and other incomes such as those of the self-employed (O). It is also equal to the sum of spending: consumer spending (C ), government spending (G), investment (I) and net exports (NX). Rearranging these gives us an expression which tells us the counterparts of changes in profits. It’s:
P = (C – W) + I + (G – T) + NX – O.
This simply tells us that profits rise when aggregate demand rises and the increase does not flow to other incomes such as wages and taxes; I’m speaking here of domestically generated profits, and am excluding profits from firms’ overseas operations.
My table shows how these counterparts moved profits between 2009 and last year. In this time, profits rose only one per cent despite a 13.8 per cent rise in money GDP. This was because of some powerful offsetting forces.
|Counterparts to changes in UK profits 2009-13, #bn|
The biggest positive for profits has been a rise in consumer spending relative to wages. This is due in part to consumption smoothing: if we expect a fall in our real wages to be only temporary, we will try to maintain our spending by borrowing or running down savings. When this happens, firms will get more through the front door in the form of revenues than they lose through the back door in the form of wage costs.
A second boost to profits has come from rising investment.
These two stimulants have been offset by two depressing factors. One has been a fall in government spending relative to taxes; the government deficit in national accounts terms has shrunk. (This does not necessarily imply that austerity has caused profits to fall; you could argue that consumer spending and investment have risen because austerity has reduced interest rates and expected future taxes – but this is another story.)
The second force for lower profits has been less discussed. It’s that other incomes have risen. Most of these are the incomes of the self-employed, whose numbers have risen by more than 10 per cent since 2009. In this sense, profits have fallen because economic activity has been diverted away from the corporate sector towards the self-employed. If we spend our money at market stalls rather than in big retailers, aggregate profits tend to fall.
We can use this framework to think about the outlook for profits. Doing so immediately gives us two warnings. One is that austerity will remain a drag upon profits (in simple mathematical terms at least) because whoever wins next year’s general election will try to reduce G – T. The other is that it is unlikely that net exports will add much to profits. This isn’t merely because our main trading partner (the euro area) is growing slowly, or because globalized supply chains mean that any rise in exports is accompanied by higher imports. It’s also simply because net exports are small relative to profits and so can’t make a big contribution to them.
In this sense, profits will fire on only three of our five cylinders, at best.
The good news is that most economists agree that investment will rise; one firm’s spending, remember, is another’s income. This leaves two questions.
The first concerns the path of C – W. The danger here is that falling unemployment will lead to higher wage growth, and workers won’t return the cash to companies in the form of higher spending but will instead use the extra cash to save or reduce debt. It’s usually the case that when incomes rise spending doesn’t increase one-for-one immediately.
This, though, isn’t certain. As David Bell and Danny Blanchflower show, there might be more excess supply in the labour market than generally thought. If so, then wages won’t rise much, which could allow consumption smoothing to continue to raise profits.
The second question is: will self-employment continue to expand at the expense of the corporate sector?
There’s one reason to think so. Some of the self-employed are under-employed and earning little; freelancers and handymen are sitting waiting for the phone to ring. As the economy grows, some of these will move into employment, thus expanding the corporate sector and profits and the expense of the self-employment sector.
What’s at stake here, however, isn’t merely a macroeconomic issue but a cultural one. Will more of us want to escape corporate drudgery for the autonomy of being our own boss? Will consumers continue to shift away from corporate suppliers to non-corporate ones such as peer-to-peer lenders, file sharers, pop-up restaurants and farmers’ markets? If so, then decorporatization will continue to squeeze profits.
Yes, there is a bullish story you can tell in which investment booms, wages stay low whilst consumption smoothing raises profits and decorporatization goes into reverse. But this is by no means certain.
It is, therefore, risky to bet upon a big sustained rise in domestically generated profits. But this is a bet which equities seem to be making. Since 2011 smaller stocks – whose profits tend to come more from the UK than larger ones – have out-performed the FTSE 100. As a result, yields on these stocks and lower and price-earnings ratios are higher than on the multinational-dominated FTSE 100. This implies that markets are betting on domestically-generated profits growth. This bet might pay off. But then again…