The Profits Wave

On March 23rd of last year, at the start of the coronavirus pandemic, the S&P500 briefly traded below 2,200.? Since then it has more than doubled, surfing on a wave of corporate profits, in a sea of central bank liquidity.? However, investors should recognize that this wave will face challenges going forward while the tide of monetary easing should turn.? As this happens, a focus on valuations should be more rewarding than has been the case in recent years.

This Thursday, the Bureau of Economic Analysis will release revised GDP numbers, along with its preliminary assessment of corporate profits for the second quarter. The next day, Federal Reserve Chairman, Jerome Powell, will speak virtually to the Annual Jackson Hole conference.??

Investors around the world will, of course, pay much closer attention to the second of these events than the first.? Any indication on when and how the Fed may begin to taper its massive bond purchase program could have significant and immediate impacts on global financial markets.

However, it is also worth looking closely at the profit numbers and how they were achieved.? The GDP accounts provide a particularly useful snapshot of the entire picture, including compensation costs, corporate taxes, depreciation, rent and net interest.? This allows us to look at after tax profits from the top down – as the last slice in a big national income pie.? One way for profits to grow is for the pie simply to expand.? Another is for the profit slice to expand at the expense of the other slices.? Both of these phenomena have been on full display in recent years and we expect after-tax profits to set a new, all-time record in the second quarter, mirroring the performance of S&P500 operating earnings.? The question is: can this profit surge be sustained???

The first issue is the size of the pie itself.? While from an accounting perspective, profits are part of national income, the growth of national income is very closely tied to the growth in nominal GDP.? We expect revised data to show nominal GDP rose by 16.9% year-over-year in the second quarter, in a dramatic bounce-back from a deep recession a year earlier.? Powered by continued reopening activity, inventory rebuilding and some further fiscal stimulus, we expect nominal GDP growth of a still very strong 9.3% over the next year.? However, in the following year, that is between the second quarter of 2022 and the second quarter of 2023, nominal GDP growth could fall to 5% or less, as economic growth is severely constrained by limited labor supply and potentially divided government after the mid-term elections shuts down further Washington aid.?????

Consequently, even if the economy avoids a recession over the next few years, the national income pie is likely to grow much more slowly.? But how about the relative size of the slices?

The most important slice is employee compensation which fell from 57% of GDP in 2000 to 52% by 2011 but which has since risen to 54%.? Over the next year, even with hourly wages growing at an annual pace of close to 5%, a lack of available workers in a surging economy will likely continue to result in strong productivity growth and the compensation share of GDP should drift down.? However, in the following year, as growth slows in an economy with very tight labor markets, compensation should grow faster than the economy overall.

Interest and rental costs should also remain low in the year ahead as companies are able to take advantage of locked-in lower bond interest rates and low-priced lease agreements from the pandemic.? Depreciation expense should also remain low, reflecting a 5.2% drop in business fixed investment last year.? However, these expenses also should drift up in 2022 and beyond.?

Corporate tax expense, should also move higher in 2022.? While considerable uncertainty surrounds the reconciliation bill which the Administration is hoping to push through Congress this fall, it is likely to increase the statutory corporate tax rate to at least 25% from its current 21%.? In 2019, before the onset of the pandemic, the effective average corporate tax rate was 12.8%?? Extrapolating from the impacts of the 2017 corporate tax cut suggests that boosting the corporate tax rate to 25% could add about 2 percentage points to this effective tax rate in 2022 and beyond.?

Corporate profits also generally benefit from a falling dollar and rising oil prices.? In the second quarter, the broad trade-weighted dollar was down 8.2% year-over-year while the price of a barrel of West Texas Intermediate Crude Oil was up 135%.? Neither of these variables should be a major factor in boosting or dragging on profits over the next year.??

Overall, this suggests that the year ahead could still see some gains in corporate profits but that subsequent years will likely be much tougher.? This is a somewhat sobering thought since the S&P500 is already selling at a forward P/E ratio of 21.2 times earnings for the next 12 months, far above its average of 16.75 times seen over the past 25 years.

Of course, elevated valuations of U.S. equities and assets in general have been facilitated in recent years by very low interest rates.? This, in turn, is largely due to very easy monetary policy from the Federal Reserve.? Later this week, at the annual Jackson Hole Federal Reserve Conference, we expect Fed Chairman Jay Powell to provide some hints on the Fed’s thinking both on tapering bond purchases and, eventually, raising short-term interest rates.

He is unlikely to lay out an exact timetable for either of these policy moves in this speech.? While economic data continue to look solid, there remains significant uncertainty about the course of the pandemic.? In addition, the Fed would prefer to know the stance of fiscal policy before committing to a direction for monetary policy.? If everything goes according to the Administration’s plans, both a bipartisan infrastructure bill and an omnibus reconciliation bill will be signed into law this fall, without a government shutdown or a debt-ceiling crisis.? However, the longer negotiations continue, the greater is the risk that something goes wrong with the political calculus and the Fed would prefer to be past this uncertainty before commencing tightening.??

That being said, the minutes of the July FOMC meeting explicitly stated that most participants noted that “…provided the economy were to evolve broadly as they anticipated, they judged that it could be appropriate to start reducing the pace of asset purchases this year…”? This, along with Chairman Powell’s promise of advance notice before making any changes to purchases, suggests that at either the September or November FOMC meeting, the Fed will lay out a plan to reduce asset purchases from the current $120 billion per month to zero, with the tapering starting in December and potentially moving in $15 billion per month increments.

As the Fed tapers, and provided the economy continues on the road to full employment with a winding down of the pandemic, reduced policy uncertainty and still elevated inflation, long-term interest rates should finally move up from extraordinarily low levels.? As they do this, funding for the most speculative investments in financial markets could become harder.? Within the U.S. stock market, this should lead to a compression in valuations, favoring value stocks over growth stocks.? More generally, this move should favor assets which still look reasonably priced from a valuation perspective over those which have long surfed on the foam of a wave of excess liquidity.

Disclosure

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