Still no real recovery in US profits
After a very strong corporate earnings season, last Friday delivered the first estimate of profits as tallied by the US national income and product accounts, or NIPA. Unfortunately, the NIPA data pours cold water over the notion that the US is seeing a real, widespread recovery in profitability. The non-financial corporate sector of the US economy (not exactly a niche segment) is experiencing nothing of the sort. Instead, real profitability continues to slide.
This may come as a surprise to many readers. In aggregate, S&P 500 companies just reported year-on-year nominal earnings growth of nearly 15% in the first quarter — the strongest growth since 2011. The biggest contribution came from the energy sector, which saw a dramatic rebound in sales and profitability as oil prices recovered from $30/bbl early last year, to around $50 this year. Financials, materials, and tech also saw strong earnings growth.
Comparing NIPA profits to corporate releases, it appears that much of the reported nominal profit growth came from three areas: (i) growth outside of the US, (ii) financials, and (iii) inflation. Growth improvements in the rest of the world should not be discarded, and neither should profits in the financials sector. But it is worrying that, after adjusting for inflation, profits in the domestic nonfinancial sector continue to decline in real terms. After another strong earnings season, investors could reasonably have hoped for at least a marginal improvement in real profits. As the first chart below shows, they got nothing of the sort.
Inflation has a way of making corporate profits look better than they really are. 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 — as articulated over 100 years ago by Ludwig von Mises, in his classic work ‘The Theory of Money & Credit’.
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). I extend their logic a step further, applying what I call a “working capital adjustment” (or WCAdj). This accounts for the fact that working capital requirements, like inventories and fixed assets, also rise and fall with inflation. Therefore, during periods of inflation a portion of inflows needs to be added to working capital rather than treated as distributable profits. After these adjustments, whatever profit is left over can then be deflated by a price index. Alas, real profits have been declining since 2015.
With profits down, the rate of return on invested capital in the US also continues to slide. In consequence, my various Wicksellian spreads between the return on capital and the cost of borrowed capital have narrowed further. In aggregate, they now suggest reducing equity exposure to around 16% of full-risk levels, from 20-25% before Friday’s data release (
As they reduce equity exposure, investors should overweight treasuries of short to medium duration (averaging out the model’s suggestion for a sizable position in long bonds and an even bigger position in T-bills). Keeping treasury duration at or below average also makes good sense with the Federal Reserve gearing up to begin winding down its balance sheet later this year.
Could profit growth improve going forward? Sure. But with Washington engulfed in “Russiagate”, it looks increasingly unlikely that Donald Trump’s administration will have either the time or the political capital to deliver on promises to boost ROIC with bold reforms of the US tax and regulatory codes. For now, I suggest investing according to the facts on the ground. Further pare risk exposure.