What to do with Record Corporate Profits?

Popular Economics Weekly

U.S. corporations continue with record-breaking profits in Q1 2011. So what is wrong with the downturn in stocks, employment, and depressed consumer sentiments? Nothing, really, except corporations refuse to spend their profits. Of course, economies never recover in straight lines, consumers and government still have too much debt to ‘goose’ growth substantially after the greatest recession since the Great Depression, but corporations don’t seem to want to contribute to that growth just yet. That is why Bernanke and the Federal Reserve have to continue to hold down interest rates.

Consumers are still cash-strapped, as we said. That has resulted in the slowdown of GDP growth from 3.1 percent in Q4 2010 to 1.9 percent in the first quarter.

A good measure of consumer demand is Final Sales of Domestic purchasers, and consumer make up approximately 70 percent of domestic Final Sales. Final Sales had been rising 2-3 percent during the housing bubble, largely because consumers were using their home’s equity as a checkbook, but is now down to 0.4 percent annualized. It has never returned 2 percent since Q4 2007, the beginning of recession.

But corporate profits continue their surge in the first quarter; up an annualized 35.2 percent following a 12.6 percent drop the quarter before, and were up 7.8 percent on a year-on-year basis. This has resulted in something like a $1 trillion cash hoard held by the S&P 500 largest corporation, according to the latest data. In other words, corporations are not expanding their businesses.

When will businesses begin to spend their cash hoard? Only when so-called effective demand picks up, and that won’t happen until those debts are paid down. All household debt including mortgages still totals more than 100 percent of household assets. That is why demand is down across the board, whether for durable goods (that last more than 3 years), or services. This means incomes have to substantially increase as well.

The good news is that increases in durable goods orders for the latest month were broad-based by industry.  Transportation led the way with a monthly 5.8 percent jump, following a 9.4 percent drop in April.  The swing in both months was largely nondefense aircraft (Boeing) which surged 36.5 percent in May after a 29.0 percent fall the month before.  Defense aircraft rebounded 5.5 percent after a 0.4 percent dip.  However, the auto industry appears to still be suffering from supply shortages.  Motor vehicles edged up only 0.6 percent, following a 5.3 percent fall in April.

Household net worth, the best measure of financial health, is also improving. It is at 370 percent, above the long term average of 350 percent, according to the Federal Reserve’s latest Flow of Funds report, while the personal savings rate is hovering around 5 percent, meaning that consumers are saving enough to continue to pay down their debts, as we said last week.

The Federal Reserve Bank of San Francisco also believes that corporations won’t open their pocketbooks until household debt levels decline further. “If the main problems facing businesses relate to depressed consumer demand due to a household sector weighed down by debt, investment tax subsidies and lower interest rates may have a limited effect on business investment and employment growth,” said a recent SFFRB report. “The evidence is more consistent with the view that problems related to household balance sheets and house prices are the primary culprits of the weak economic recovery.”

One would think higher corporate profits should mean corporations will eventually have to hire more workers, if they want to stimulate a greater demand for their products and services. Higher profits also mean a lower price-to-earnings ratio for stock values (earnings being the denominator in the P/E ratio), which has been hovering around 15:1 for the S&P 500 largest corporations of late. And a P/E ratio below 15:1 has historically boosted stock prices. So let us hope this new report gives a boost to stock prices for the rest of the year.

Harlan Green © 2011