The burden of the sharp slowdown in nominal growth since the middle of 2014 has been borne disproportionately by corporate America. Between Q3 of that year and Q2 of this year, the year-on-year (y/y) growth rate of gross disposable income (GDI) has fallen from 5.6% to just 2.4%, while the y/y growth rate of the corporate profits of domestic industries (after inventory valuation and capital consumption adjustments, as well as taxes) has plunged from 8.7% to -9.8%. Over the corresponding period, the y/y growth rate of the compensation of employees has also decelerated, but much more mildly, from 4.7% to 3.8%. This was sufficient to send the four-quarter moving average (4-qma) of the corporate profit share in Q2 (the ratio of profits to GDI using the same definition of corporate profits) to just 5.9%, which was the lowest share since Q1 2010. Critically, when we break down those after-tax corporate profits into those distributed to shareholders and those that are undistributed, we find that US corporates have been doing their upmost to protect their equity investors from the corporate profits recession at the expense of funds available for capital spending. Whereas the 4-qma of the net-dividend share of GDI is only 0.4 percentage points lower than its peak in Q1 2014 and is still above average through the previous business cycle, the undistributed profit share of GDI has hit its lowest level since Q3 2009 (see Chart 2).
Because profit recessions in previous business cycles were usually either associated with economic recessions, or foreshadowed them, there are a number of prominent voices still calling an end to the current business cycle. We think this is premature for three main reasons. First, although undistributed corporate profits (or internal funds) have fallen significantly in recent years, at 1.5% of GDI they still remain comfortably above the levels associated with the past four recessions, including the comparatively mild early-2000s recession. Second, the current profits recession has been less broadly based than previous profits downturns; with most of the industry sectors experiencing negative profit growth concentrated in or highly exposed to the energy such as utilities and petroleum and coal production, as well as parts of the manufacturing sector such as machinery production (see Chart 3). Many service sectors have retained positive profit growth in recent quarters, though few have escaped deceleration altogether as weaker domestic and foreign demand has filtered through most parts of the economy.
The third and most important reason is that the profit recession was mostly attributable to factors are now beginning to fade. For example, oil and bulk commodity prices are now up more than 50% from their February lows, the USD has stabilised after appreciating rapidly through 2014 and 2015, and domestic and global manufacturing conditions are showing early signs of revival. While we will not get national accounts corporate profit data for Q3 until late November, listed corporate profits for the third quarter have mostly beat estimates and appear to be on track to record slightly positive y/y growth for the first time since Q2 2015. We are not expecting an especially strong turn up in corporate profits over the next few quarters given the subdued nature of overall demand and the tightening labour market, but even an extended period of modest profit growth would help to extend an economic cycle that is already more than seven years old.
Jeremy Lawson, Chief Economist – Standard Life Investments