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US corporate profits: Now you see them, now you don't

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      By Jeffrey A. Rawlins, CFA, Director of Investment Research - Global Income, Eaton Vance Management and Stewart D. Taylor, Investment Grade Fixed Income Portfolio Manager, Eaton Vance Management

      Boston - In late July, the Bureau of Economic Analysis (BEA) released annual revisions to the last five years of National Income and Product accounts (NIPA) data. They do this as they replace initial estimates with more reliable census, federal budget and Internal Revenue Service data. Usually the revisions are non-events, confirming the more granular S&P operating earnings and margin data investors rely on. The July 2019 revision was far from routine, as almost five years of corporate profits vanished. In essence, all-economy corporate profits, rather than rising sharply, stagnated over the last five years. The downward revision was mostly because of two factors: higher rates of employee compensation and weaker revenues.

      While the lead time varies, NIPA profits and profit margins generally lead S&P profits and margins. This has been particularly true at economic cycle turning points. For instance, NIPA profits peaked in September 1997, well before the technology-fueled S&P profits topped in September 2000. They also topped in September 2006, a full year ahead of the S&P profits. If the pattern holds, S&P profitability and margins should weaken over coming quarters. And if margins weaken, either equity and credit markets may correct or investors may need to accept levels of valuation historically correlated with poor forward returns.

      StuChart1StuChart2

      Source: MacroBond, 3/31/19.

      Compensation costs: While the revision has negative implications for corporate margins, it is good news for workers. Data had suggested that labor's share of profit had been declining for the last four years. With the revision, the decline became a significant increase. It's now clear that employment compensation has been growing faster than corporate revenue. As long as the unemployment rate remains low, we think that labor's portion of profits will continue to increase.

      Other margin pressures: Many of the secular forces that have improved margins over the last several decades appear to be reversing. Tax rates have been falling for 70 years, globalization has been extremely beneficial to margins as cheap labor became accessible and tariff rates fell, and the lack of government interest in pursuing antitrust actions has allowed consolidation and pricing power. Now, however, budgetary constraints make additional tax cuts unlikely, globalization is reversing and there is growing interest in pursuing antitrust action.

      Conclusions: The revisions suggest profitability and margins have been weaker than investors believed. Over the last seven years, after-tax profit growth has been flat (+3.6%) while the S&P has doubled in price. By extrapolation, most of the gain has been due to multiple expansion rather than increasing profitability.

      Bottom line: Because much of the margin compression is coming from the cost of compensation and compensation trends are sticky, we expect margins will continue to come under pressure. Since NIPA data tends to lead the S&P data at cycle turning points, it is likely the S&P data and markets may begin to reflect the deterioration in coming quarters.

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