The profit illusion
Inflation has a way of making things look better than they really are. This is especially true of corporate profits. After a dismal first half last year, S&P 500 companies reported an earnings recovery in 2H16. In the final quarter, they posted profit growth of 6% YoY (with or without financials). Alas, this recovery appears to be a mirage, caused by accelerating inflation. Using official flow of funds data for the domestic non-financial corporate sector, and adjusting for the effects of inflation, I find that US corporate returns, in real terms, were flat YoY in 4Q16. There has been no recovery in profits.
One might think that 6% nominal profit growth, in the context of 1.5-2% inflation, would give positive profit growth in real terms. It does not. It is not enough simply to deflate headline profits by an inflation index. The trouble is that conventional accounting does not adjust for the rising cost of replacing capital, such as depreciating assets and inventories. Inflation pushes up revenues, while depreciation and the cost of goods sold are deducted based on historical costs. This makes profits look greater than they really are. This problem was articulated over 100 years ago by Ludwig von Mises, in his classic book, “The Theory of Money & Credit”:
“If the value of money falls, ordinary book-keeping, which does not take account of monetary depreciation, shows apparent profits, because it balances against the sums of money received for sales a cost of production calculated in money of a higher value, and because it writes off from book values originally estimated in money of a higher value items of money of a smaller value. What is thus improperly regarded as profit, instead of as part of capital, is consumed by the entrepreneur or passed on either to the consumer in the form of price reductions that would not otherwise have been made or to the labourer in the form of higher wages, and the government proceeds to tax it as income or profits. In any case, consumption of capital results from the fact that monetary depreciation falsifies capital accounting.”
Thankfully, the US flow of funds statisticians provide their own measures of corporate profits, adjusted for changes in the replacement costs of fixed capital and inventories (named “capital consumption adjustments” or CCadj, and “inventory valuation adjustments” or IVA). After making these adjustments, whatever profit is left over can then be deflated by a price index. The resulting measure of real profits fell dramatically in 2015, and was basically flat over the course of 2016. In 4Q16 profits were actually down a touch versus 3Q, but the broad story is that profits are flat. There has been no recovery.
The result is that return on invested capital in the US continues to slide (see the chart). And with interest rates across the curve having risen in recent months, my various Wicksellian spreads between the return on capital and the cost of capital have narrowed further. Although the Fed softened its hawkish tone last week, it still hiked rates, and it plans to hike further this year. Investor hopes are high that these increases will be more than offset by a rebound in returns—thanks to rising animal spirits and possible policy reforms. Perhaps. But for now those are just hopes. The facts on the ground still call for caution.
With the latest data, my Wicksellian spreads are not yet flashing red. But they are now glowing a very dark orange, as the most topical spread, based on the Fed Fund rate, suggests ( According to my model, equity risk exposure should now be reduced to roughly one quarter of full risk-on levels. Instead, investors should overweight cash and treasuries (possibly throwing gold and gold miners into the mix, as recently argued by Louis Gave.