HIGHER profits are generally seen as the most positive factor for stockmarkets. Over time, such profits should lead to more cashflows for investors in the form of dividends or buy-backs. American profits have rebounded very strongly since the 2009 recession and relative to GDP are close to a post-1945 high. In cyclically-adjusted terms, share prices are very high relative to profits (the Shiller p/e is 25.4). Just as a stock with a high p/e implies market expectation of rapid future profits growth, the same must apply to the overall market.
So it should be a cause of concern to investors that, on the MSCI measure of operating profits, profits have now fallen over the last year (see graph).
This measure is not the one most commonly quoted by brokers, who focus on the pro forma measure supplied by IBES, which still shows profits rising on an annual basis. But, as Andrew Lapthorne of Societe Generale points out, this measure has been boosted by a rebound in profits at a number of companies, such as Hewlett Packard, which had big writeoffs in 2012 that are now dropping out of the annual comparison.
The issue of whether the share of profits has moved to a permanently-higher level is one of the most interesting in modern economics, relating as it does to inequality as well as to markets and business investment. One explanation is that the world economy has moved decisively in favour of capital and away from labour, thanks perhaps to technology or to the vast addition to the workforce that has resulted from globalisation. But even if that explanation holds water, that raises a second question, why does it not get corrected by the normal competitive process? If the return on capital is high, then more capital will be invested by eager entrepreneurs and the resulting competition will drive returns back to a more normal level. But business investment in the developed world has not rebounded in the way that many policymakers had hoped. Is this down to incentives, as Andrew Smithers has suggested; executives do not pursue capex because it will dent earnings per share and thus the value of their options? Or is it down to the fact that business investment is all occurring in the developing world? China has a phenomenal investment rate.
That leads to another issue; is the high level of US profits merely down to the success of its multinationals in overseas markets? That is the view of Capital Economics which says that
Corporate America is much more active in the rest of the world today than it was at the turn of the century. Although US-based “parents” continue to account for the lion’s share of the output of US MNCs, the share accounted for by their majority-owned foreign affiliates (MOFAs) has risen sharply.
This rapid growth at US MOFAs owes much to the expansion of Corporate America in emerging markets. The value added by those in developing countries nearly quadrupled between 2000 and 2011, whereas the value added by those in other advanced countries merely
Such a shift in production has reduced average labour costs at US MNC’s international operations. And it has also exerted downward pressure on wages in the US economy itself. The flipside of falling labour costs has been increased profitability. Over the same period, pre-tax profit per unit of output rose from 28% to 41% at US MOFAs, and from 21% to 25% at US parents.
That view raises the question of whether the continued health of US corporate profits depends on events in emerging markets (it surely can’t be Europpe that has helped in recent years) that are now slowing. Or indeed whether the (so far) modest slowdown in China and the dramatic weakening of the yen is sending a deflationary force to the west in the form of lower import prices; Spain slipped back into deflation on the latest data; German import prices are down 2.7% year-on-year.
All told, the seemingly widespread impression that the outlook is set fair for a rapid global recovery in 2014 seems misguided.
28 March 2014 | 1:56 pm – Source: economist.com