Fierce debate has been raging as to whether rising US corporate profits are sustainable or likely to shrink, leaving the market overvalued. Consideration of some of the key contributing factors will enable us to assess if and when this is likely to occur.
Interest Rates
Low interest rates are clearly boosting corporate profits. The inverse relationship is evident from the strong profits recorded in the 1950s, when corporate bond rates were lower than at present, and also the big hole in profits in the 1980s, when interest rates spiked dramatically during Paul Volcker’s reign at the Fed.
The outlook for inflation is muted and the rise in interest rates is likely to be gradual and over several years, rather than a sharp spike, if the Fed has its way.
Employee compensation
Employee Compensation as a percentage of Net Value Added (by Corporate Business) has fallen sharply since the GFC, boosting corporate profits. Again we can observe an inverse relationship, with corporate profits spiking when compensation rates fall, and vice versa.
A sharp fall in unemployment would send wage rates soaring, as employers bid for scarce labor. But that is not yet on the horizon and we are likely to experience soft wage rates in the medium-term (one to two years).
Corporate Tax Rates
The third element is the effective corporate tax rate which has fallen to an historic low, post GFC. Part of this can be attributed to tax losses incurred during the GFC, used to shield current income. The effect is likely to be short-lived, causing effective tax rates to drift upwards, towards pre-GFC rates around 24%.
Conclusion
The sharp rise in corporate profits is unsustainable in the long-term, but adjustments in the medium-term are likely to be modest. Higher wages and interest rates will have a more significant impact in the long-term, but are only likely to occur when sound economic growth is restored — which in turn would have a compensatory effect on corporate profits.
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