Serious Money: Corporate America is enjoying the best of times and looks set to register its 17th consecutive quarter of double-digit earnings growth during the current reporting season.
Return on equity is running at about 18 per cent against an historical average of 12-13 per cent. The after-tax profit share of gross domestic product (GDP)is at a post-second World War high of more than 9 per cent and is more than three percentage points above the historic average. These are impressive statistics against a background of rising raw material prices and debt-servicing costs.
The stellar performance of the US corporate sector today is in sharp contrast to just four years ago when big business suffered under a cloud of suspicion amid a stream of scandals that included the largest recorded bankruptcies in financial history. But what has brought about this turnaround in the corporate sector's fortunes and, more importantly, can it be sustained?
It is important to appreciate the dynamics of aggregate supply and demand to gain an understanding of the nature of the current economic expansion and earnings cycle. Many analysts focus almost exclusively on aggregate demand without regard to supply, but how the two interact provides a more complete picture of the cycle and the outlook.
Imagine a simple economy with no government and foreign trade. Productivity and employment are the primary determinants of supply. Consumption and investment constitute the main sources of demand. The former is driven primarily by wages while the latter is a function of corporate profitability.
To maintain economic balance, aggregate demand must equal supply. If wage gains fail to keep pace with improvements in productivity, then supply will tend to exceed demand, leading to an inventory overhang and a reduction in corporate profits. Businesses will reduce investment, and employment and an economic recession will inevitably result - unless households borrow to absorb the excess supply.
Monetary policy needs to be engineered to keep interest rates low enough to make new debt affordable and to ensure that increases in household wealth are high enough to engender confidence among consumers to take on more debt. Economic balance will be maintained and corporate profitability will soar as wages decline as a percentage of business revenues. This is a reasonably accurate description of the private sector today. Big business finds itself flooded with cash while households are drowning in debt.
This is the true legacy of the so-called maestro, Alan Greenspan. The current economic expansion has entailed the strongest productivity cycle on record. But job gains have been anaemic, with monthly payroll numbers running at one-third the pace of the 1990s while the wage and salary share of GDP remains at cycle lows, despite almost five years of economic expansion. Indeed, median household income has declined in the past five years. Consequently, demand has struggled to keep pace with supply throughout this cycle.
However, the decision by the Federal Reserve five years ago to cut short-term interest rates to the lowest levels since the 1950s and the accompanying decline in mortgage rates to the lowest levels in 40 years enabled a housing boom to replace the euphoric stock market of the 1990s as the primary source of increased household wealth.
While the ratio of household financial assets to liabilities reached a record low in the third quarter of 2005, the ratio of total household assets to liabilities remains at a respectable level. The confidence engendered by the housing boom has caused the debt burden of households to increase at an exponential rate, enabling the US corporate sector to post record profitability.
Outstanding consumer debt as a percentage of disposable income has reached record heights of 127 per cent. Since 2000, the ratio of debt to disposable income has increased by more than six percentage points a year. In the half-century to 2000, the ratio increased by less than one percentage point a year.
Almost half of the increase in the ratio since 1950 has taken place in the past five years. Additionally, despite low interest rates, debt-service payments have reached record highs. Including mandatory payments such as property taxes, insurance and household utilities, the US consumer has never been so financially stretched in the post-second World War era. The number of firms specialising in buying and collecting unpaid debts has increased from just 12 a decade ago to more than 500 today.
The recent trends in household finances are clearly unsustainable in the long run. In the short term, recent developments suggest that the rapid accumulation of debt may come to an end. The US housing boom appears to be over. Price appreciation in June slowed to the lowest level in 11 years while the inventory of unsold homes rose to a nine-year high. This is likely to be the catalyst that causes a sustained slowdown in the US economy. It is too early to tell whether it alone is enough to bring almost 60 consecutive quarters of growth in real consumer spending to an end. However, financial institutions will almost surely curtail their loose lending standards of recent years, leaving cash-strapped consumers with little ammunition to drive the economy forward.
The risks of a recession are rising and, given that the US consumer accounts for 70 per cent of the US economy and roughly one-fifth of the world economy, the negative implications for corporate profitability are clear. Nothing more than pedestrian growth can be expected for 2007. The return of market volatility in May looks set to stay as the risk of a bear market continues to rise. It's time to reduce exposure to stocks.
Charlie Fell is an independent consultant and lectures in finance and investment at UCD and the Institute of Bankers in Ireland.
