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The New Yorker's James Surowiecki penned a widely read and perfectly cogent argument that high U.S. corporate profit margins can be sustained because of globalization, declining wage costs and low corporate taxes. We beg to quibble.
On corporate taxes, there's no argument – current policy is a major boon to corporate profits. As Mr. Surowiecki points out, "In 1951, corporations had to pay almost half of reported profits in taxes. Today, they pay only around 20 per cent."
Regarding globalization, the ground is less certain. It is true, on one hand, that 46 per cent of S&P 500 earnings are now derived overseas when even 20 years ago foreign profits were negligible.
But this explains why profits have climbed, not why they're sustainable. Declining global GDP growth has caused an epidemic of central bank rate cuts of late – Australia, South Korea, Vietnam, Sri Lanka, Poland and Turkey forms only a partial list – which suggests that global revenue growth will be difficult to come by. Europe remains an economic basket case, importing little, and YUM! Brands' troubled Asian expansion has highlighted how revenue growth in China can become a double edged sword.
Undeniably, stagnant U.S. wage costs have been a driver of corporate profit margins. But a growing number of economists now believe the process of minimizing workers (or "firing your own customers") is self-defeating in the longer term. Furthermore, the U.S. Federal Reserve's 6.5 per cent employment target is a tangible sign that employment and, eventually, upward wage pressure, are implicit policy goals.
The importance of low interest rates in pushing corporate profit margins higher is also notably absent from the New Yorker article. The steady decline in corporate bond yields – now hovering near 5 per cent – has increased profits in two ways. Some companies refinanced higher-priced debt and reduced interest expenses. In other cases, companies have borrowed at historically cheap rates in debt markets to buy back shares in order to support profits.
The effects of falling interest rates on corporate profits are difficult to quantify, but like much of Surowiecki's evidence, the majority of this trend is in the rearview mirror – rates can't go much lower than they are now.
Mr. Surowiecki is correct – globalization, taxes and lower wage costs have undoubtedly helped profits. But he seems too eager to extrapolate these trends far into the future. Whether through slower global growth or rising wages and taxes, corporate profit margins are likely to decline in the coming quarters. With little in the way of top line sales growth, corporate America has wrung all of the efficiencies out of its operations that it can.
Before the market crash of 1929, economist Irving Fisher famously declared that stocks had reached "a permanently high plateau." The danger now is for investors to carry similar beliefs about current U.S. corporate profitability.
Scott Barlow is a contributor to ROB Insight, the business commentary service available to Globe Unlimited subscribers. Click here to read more of his Insights , and follow Scott on Twitter at @SBarlow_ROB.
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Scott Barlow