Strong corporate profits amid weak economy - What's up with that?

McClatchy NewspapersMarch 27, 2011 

WASHINGTON — U.S. corporations continue to post strong profits quarter after quarter, even as the unemployment rate remains high and the U.S. economic recovery plods along in fits and starts. What gives?

Corporate profits grew 36.8 percent in 2010, the biggest gain since 1950, according to Friday's latest report from the Bureau of Economic Analysis. No sign could be more clear that U.S. companies see the so-called Great Recession in the rearview mirror.

The strong profits, however, mask the continued difficult terrain for businesses. Yes, profits are high, but that doesn't mean business is strong.

"It's not that they're fake, it's that they're generated through a bunch of economic anomalies that are not the normal course or normal factors that generate profits," said Martin Regalia, chief economist for the U.S. Chamber of Commerce, America's premier business lobby.

Regalia and other analysts think several factors are behind the strong profits, which seem to contradict other indicators of an underperforming economy, especially the 8.9 percent unemployment rate. These factors include record low interest rates since late 2008, muted demand for borrowing by companies and a surge in productivity that has allowed companies to do more with the same number of workers or fewer.

Profits aren't rising solely because companies are making and selling more widgets to keep up with customer demand, which would be the case in a healthy, booming economy. Instead, they're more profitable because it now costs less to make the same widget, often because there are far fewer workers needed to make it.

"We've been able to generate record profits on very, very low volume and very weak economic growth," Regalia said.

That's not to say things aren't improving. Over the past six months, the economy has gathered steam, and demand is picking up — from factory orders for parts needed in assembly, to a rebound in automotive manufacturing, to consumer purchases rising.

That's a healthy growth trend, but the bigger part of the story remains workforce reductions, technological advances, low lending costs and minimal borrowing. All have combined to give companies unusual control over their balance sheets, and thus their profits.

"If you are looking at where profits are coming from ... cost control, strong capital discipline, strong control over the balance sheet, that's why you've seen this extraordinary recovery in profits, even though top-line growth hasn't been spectacular," said Aaron Smith, a senior economist at forecaster Moody's Analytics.

Another factor in today's strong corporate profits also might mask how sluggish the U.S. recovery has been — the growing percentage of profits from foreign sales by U.S. corporations.

That number climbed steadily over the past decade and peaked at 45.3 percent in 2008. That underscores how globalization has made it harder to define winners and losers. Americans are wrestling with high unemployment, but overseas sales have boosted U.S. corporate profits. That, in turn, lifts the stock market, which lifts the wealth of workers with 401(k) retirement plans and company shareholders alike.

"Earnings from abroad have become more important to U.S. companies. That trend has been in place for a couple of decades now, but really in the past decade we've seen the share of earnings coming from abroad as a share of the total increase rather dramatically," said Smith.

Whatever the reasons, there's no getting around the fact that profits are super-sized.

"The profits recovery during the past two years is among the best, if not the best, ever. Profitable companies expand. They hire workers, buy equipment, and build more plants and offices. Capital spending on equipment has been recovering along with profits. It is up 18.6 percent over the past six quarters. Employment gains have been lackluster, but are picking up," Ed Yardeni, a veteran market analyst, wrote in a recent upbeat note to investors.

For now, the question on the minds of most Americans remains — when do increases in corporate profits actually translate into hiring? Traditionally, profits lead hiring in an economic recovery.

"Normally, profits lead by a couple of quarters both job creation and capital spending. They've been leading this time. We've had job growth, but it just hasn't been as much as we might like," said Richard Rippe, an economist with ISI Group Inc., who added that employment and capital spending are both up. "It looks like the normal dynamics are working, but it would be good if they were working a little more decisively."

Another explanation for strong corporate profits has been growth in productivity, or hourly output per worker. The Labor Department reported on March 3 that annual average productivity rose by 3.9 percent in 2010. Aside from that strong productivity growth, unit labor costs fell during the same period by 1.5 percent. That reflects that worker compensation didn't keep pace with rising output. Put another way, businesses produced more than compensation rose.

Normally, companies can squeeze only so much out of workers before they must hire more of them or fall behind competitors. Many economists thought hiring would have picked up by now as productivity rose, yet job creation continues to lag.

There's plenty of anecdotal evidence from surveys that consumers and businesses remain cautious, especially given concerns about Europe's debt crisis, conflict in the oil-rich Middle East and the crippling disaster in Japan, the world's third-largest economy.

The recent climb in oil and gasoline prices, now approaching $4 a gallon in some areas, is holding back consumer spending on other goods and renewed business activity. Fresh evidence of falling consumer confidence came Friday when the ThomsonReuters/University of Michigan survey of consumer sentiment for March dropped to its lowest level in five months. Coupled with the protracted slide in home prices, Americans aren't ready to loosen the purse strings.

The Federal Reserve on Thursday released results of an unusual follow-up survey on family finances. Given the economic shock from the Great Recession, Fed researchers wanted a better read of the impact on family balance sheets from 2007 to 2009. Its conclusions weren't surprising — those with more financial assets saw a larger hit to their wealth. But survey respondents across all income levels expressed a need for more precautionary savings.

"The data show signs that families' behavior may act in some ways as a brake on reviving the economy in the short run," the Fed report concluded.

Cautious customers don't bode well for business activity. That helps underscore how other factors explain how corporations are so profitable amid today's sluggish growth.

"Part of this is business being much more lean and mean. It's hard for me to imagine that this is going to work in reverse," Smith said.

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