Why US Profits Have Soared amid Slow Economic Gains

There seems to be a disconnect between US corporate earnings and the state of the economy these days. Aggregate profits are growing at a blistering pace, although the economic growth remains relatively modest.

You can see this in preliminary data on third-quarter gross domestic product (GDP), which shows that US operating profits rose to $2.04 trillion, according to our analysis. That’s an annualized gain of 22% over the second quarter of 2011 and 11.3% ahead of the third quarter of 2010.

Profits are even more impressive when we look back to the start of the economic recovery in mid-2009. Since then, US operating profits have posted a cumulative gain of 61.6%—10 points higher than the postwar average (Display ). This wasn’t just the result of high earnings abroad: earnings from domestic operations alone have jumped 70%, 13 points higher than the average in previous recoveries. Yet, over the same period, the cumulative growth of nominal GDP has been 9.7%—less than half the average of the six recoveries in the past 50 years. A Robust Profit Cycle in a Weak Recovery How are companies managing to boost profitability so much amid such weak economic conditions? I think there are two key explanations: improved productivity and low interest rates. After a recession, companies often improve profitability by raising prices higher than unit labor costs. Labor cost growth tends to be restrained in the initial stages of recovery because companies aren’t yet hiring many new workers. In the current recovery, price increases have been running at a relatively modest 1.8% per year, but the job market remains so soft that the cumulative rate of price increases has exceeded the change in unit labor costs by five percentage points—the widest gap in 50 years.

Low interest rates have helped by reducing capital costs. Net interest payments of nonfinancial companies fell to an estimated $100 billion (annualized) in the third quarter of 2011, from about $155 billion at the start of the recovery.

Nonfinancial companies now have the highest profit margins since the 1960s. According to the GDP data, inflation-adjusted profit margins reached about 15% in the third quarter—a record increase of nearly six points since the recovery began.

It will be tough to match these gains next year. If the job market picks up, the gap between prices and labor costs will almost certainly narrow. And even though interest rates are likely to stay low, US companies won’t benefit much more, because capital costs have already fallen sharply. But we still forecast that US operating profits should rise by 8% to 10% in 2012—a much healthier clip than the prevailing economic gloom might lead you to believe.

Joseph G. Carson

Director—Global Economic Research
Joseph G. Carson joined the firm in 2001. He oversees the Economic Analysis team for Fixed Income and has primary responsibility for the economic and interest-rate analysis of the US. Previously, Carson was chief economist of the Americas for UBS Warburg, where he was primarily responsible for forecasting the US economy and interest rates. From 1996 to 1999, he was chief US economist at Deutsche Bank. While there, Carson was named to the Institutional Investor’s All-Star Team for Fixed Income. He began his professional career in 1977 as a staff economist for the chief economist’s office in the US Department of Commerce, where he was designated the department’s representative at the Council on Wage and Price Stability during President Carter’s voluntary wage and price guidelines program. In 1979, Carson joined General Motors as an analyst. He held a variety of roles at GM, including chief forecaster for North America and chief analyst in charge of production recommendations for the Truck Group. From 1981 to 1986, Carson served as vice president and senior economist for the Capital Markets Economics Group at Merrill Lynch. In 1986, he joined Chemical Bank; he later became its chief economist. From 1992 to 1996, Carson served as chief economist at Dean Witter, where he sat on the investment-policy and stock-selection committees. He received his BA and MA from Youngstown State University and did his PhD coursework at George Washington University. Location: New York

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