Are U.S. corporate profits near a cyclical peak? By a popular measure of “profit margins,” they appear to be. But looking a little more carefully, one finds a simple explanation for at least part of it: the globalization of U.S. corporations.
Corporate profits as a ratio to Gross Domestic Product
(G.D.P.) is often presented as a macroeconomic proxy for profit margins (Figure 1).
Figure 1
Some
analysts
wield
charts like
this
to show that profit margins are much higher than the norm. I agree that the
time series appears to be at a cyclical extreme. But this ratio is incorrect at
two levels. First, corporate profits divided by GDP is not the profit margin
per se. Secondly, and crucially, it blurs the distinction between magnitudes in
domestic terms versus national terms.
A profit margin is commonly defined as profits divided by
revenues. G.D.P. is aggregate expenditure in the economy, which is definitely not
equal to aggregate corporate revenues. It is reasonable to expect that profits
as a share of GDP and profit margins are correlated—but they are not the same thing.
A meaningful ratio would instead divide profits, which is the income of
corporations, by total income in the economy. This new ratio I interpret as the
share of total income that goes to corporations: no the profit margin, but the
profit share.
My second point is that the number in the numerator of the “profit
margin” on that chart (Figure 1) comes
from national income figures. It includes profits generated by corporations with
legal residence in the U.S., regardless of whether those profits came from U.S.
operations or foreign operations. This measure of profit includes income earned
by Amazon in the United Kingdom, and excludes income earned in the U.S. by
Toshiba. Gross Domestic Product (G.D.P.), on the other hand, captures economic
activity within U.S. borders, whether it is done by U.S. companies or foreign
companies, and excludes activity by U.S. companies abroad. It is misleading to compare these two
magnitudes: worldwide profits of U.S. corporations and GDP generated within
U.S. borders.
One
can correct this mistake. The Bureau of Economic Analysis (B.E.A.) provides
time series on national profits as well as on national income. I have collected
the data and constructed a time series of the national profit share: net
national profits divided by net national income. To gain some insight I also display
the domestic portion of national profits and the foreign portion. (This
breakdown is available on the Federal Reserve’s Flow of Funds table F.7.) The three
series are displayed on the chart below (Figure
2).
Figure 2
Total profits are at all-time highs, but foreign profits
explain part of that. The share of profits that U.S. companies obtain from
abroad is increasing. The rise has even accelerated in the first decade of the
21st century. Between 1990 and 2000, for instance, the share went up
by 0.1 percentage points; between 2000 and 2010, it increased by 1.5 percentage
points. The share of profits obtained at home, on the other hand, does not have
an obvious trend.
The cyclical component is there, especially for domestic
profits, and it indicates that U.S. profits are near a cyclical extreme. It is
reasonable to expect a cyclical correction, but perhaps not as soon or as deep
as some think. Here is John
Hussman in March 2013:
“The historical norm for corporate
profits is about 6% of GDP. The present level is about 70% above that, and can
be expected to be followed by a contraction in corporate profits over the
coming four-year period, at a roughly 12% annual rate.”
That
foreign profits are growing as a share of national income implies that the “normal”
profit share is not necessarily a fixed number, such as 6%, but a slowly rising
number. And if “normal” profits are higher than the historical average, then
the cyclical correction may be smaller than expected, or less imminent than
presumed. To be more specific, I have estimated the trend of my two time series,
foreign and domestic, of the profit share. As of 2008, the last year for which
I estimate the trend, the “normal” (i.e. trend) profit share was 12.5%. If
since then it had continued rising at the same pace as it did in 1988-2008, as
of 2012 the “normal” profit share would be 13.2%. The actual profit share was
14.4%: still too high, but by 9%, but 70% as Hussman says (Figure 3).
Figure 3
Another most reasonable proposition is that profits cannot
grow forever. Jeremy Grantham in 2006:
“Profit margins are the most
mean-reverting series in finance, and if profit margins do not mean-revert,
then something has gone badly wrong with capitalism. If high profits do not
attract competition, there is something wrong with the system and it is not
functioning properly.”
If profits kept growing, corporations eventually would gobble
up the entire nation’s income—which means that labor would earn no income at
all! My intention is not to say that profits can grow forever. But in the short
term the U.S. share of global profits could keep rising. If so, the ratio of
U.S. profits to national income could rise as well. Grantham’s statement
applies to global profits in the long term, not to every country’s profits, or
to the short term.
Will
foreign profits of U.S. corporations keep rising in the short term? I don’t know.
But I don’t know that they will not keep rising—and Hussman and Grantham don’t
know either.
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