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The profits problem

US company profits are not doing anything like as well as the stock market would suggest
The profits problem

US corporate profits are falling. Next week’s gross doestic product (GDP) figures are likely to show that they are lower than they were in 2012, which means they have fallen as a share of GDP, from just over 10 per cent then to just over 7 per cent now.

This contrasts sharply with the healthier state of the stock market. The latter, however, is dominated by some profitable monopolies, companies with large overseas earnings (which aren’t counted in the national accounts measure of profits) and a few companies, such as Tesla, that are lossmaking now, but which hope to become profitable soon. If we look behind these headline-grabbers, the reality for ordinary American companies – many of which are not listed on stock markets – is one of a grim struggle to get by.

Why? A little rearranging of national accounts data tells us the counterparts of the drop in the profit share. One is that, before the election of Donald Trump in 2016, government spending fell as a share of GDP. That fiscal restraint hurt some companies. Another is greater depreciation costs: as the economy grows, even slowly, it acquires a larger capital stock – which means companies must spend more to simply maintain existing equipment.

A third factor is that companies’ aggregate spending on wages has risen faster than consumer spending. Which means that aggregate costs of employees have risen by more than companies have got back from those employees in the form of increased spending.

It’s in this sense that the post-crisis slowdown in productivity is hitting profits. Lower productivity (than would otherwise be the case) requires companies to hire more workers for a given level of demand. And that raises costs – costs that might not be recouped, in the aggregate, by increased spending by those newly hired workers.

But of course, the causality between productivity and profits runs both ways. Lower profits tend to reduce capital spending, which in turn depresses productivity. In fact, investment now, as a share of GDP, is still well-below pre-crisis levels. A big reason for secular stagnation – the slowdown in long-term growth in productivity and GDP – is simply that lower profits have reduced companies’ motive (and funds) to invest.

This problem is intensifying. Next week’s numbers are likely to confirm that non-residential capital spending fell in the year to the final quarter of 2019. Which is consistent with weak aggregate profits.

Now, this does not mean the economy is on the verge of recession. The profit share is still higher than it was just before the last two recessions. And profits aren’t yet sufficiently weak as to force companies (in aggregate) to cut jobs.

All this does, however, help explain why both monetary and fiscal policy are astoundingly loose. Not only is the Fed keeping interest rates negative in real terms, but also the OECD expects the government to run a cyclically-adjusted deficit before interest payments this year of 3.4 per cent of GDP, the biggest deficit in the developed world.

For investors, though, this poses some nasty questions. How can profits be restored without significant capital scrapping, which would entail a recession? Can policy continue to fight against the incipient weakness of demand caused by low profits? And for how long can the contrast between weak aggregate profits and strong equity returns continue?

The fact is that American capitalism is not as healthy as the stock market would suggest. Which is dangerous.