In Defense of High Corporate Profits

Companies are doing well because vast swaths of the globe are booming, both in China and in the United States

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Over the past month, America's largest companies reported their earnings for the first quarter of the year. These quarterly reports provide as much insight into our economy as any of our leading indicators. And these results, if read correctly, highlight once again the bifurcated world we live in. Our gross domestic product is growing about 2.5 percent a year for now, but that masks a vast divergence, not between the 1 percent and the 99 but between what works and what does not. What this earnings season demonstrates is that capital and companies are thriving, along with tens of millions of people connected to those worlds, while labor and wages are not. But that is not how it is being interpreted.

The consensus among investors and the financial media is that the quarter was something of a bust, as company after company reported only modest - and in many cases, non-existent - revenue growth. "Revenue still missing as companies beat earnings," blared a USA Today headline, and that encapsulates what most have said.

The uber-bearish economist Gary Schilling, cited by the widely-read uber-gloomy blog Zero Hedge, put it bluntly: "Pricing power has been non-existent [and] sales volume increases have been very limited so the only route to profit has been cutting costs. That has pushed profit margins to all-time highs." Enjoy it now, says Schilling, because profit without revenue growth is "unsustainable." The only reason markets are doing well and corporations aren't panicking, the thinking goes, is because central banks are flooding the world with money.

At the same time, large companies have proven adept at generating substantial earnings. That is true now, and it has been true for years. Since 2009, for instance, the mega-companies of the Standard and Poor's  500-stock index have doubled their profits. Companies overall haven't done quite as well because small companies don't have the same advantages, such as keeping income offshore, assorted tax breaks and pure economies of scale. Even so, according to the Bureau of Economic Analysis, U.S. corporations overall have seen their profits grow more than 50 percent during these years.

But now, while larger companies are still showing earnings growth, revenues have been almost at a standstill. This trend is widely seen as proof that trouble is brewing. Companies, especially publicly traded ones, face relentless pressure to generate earning growth at all costs. With slower revenue growth, the only way they can do that is to cut costs and do whatever they can to become more efficient, from greater use of technology (and therefore fewer workers) to cutting wages and benefits, either by finding cheaper labor abroad or by cutting benefits and wages domestically. In a world of slow revenue growth, that becomes harder. Says Jeffery Kleintop, chief market strategist of the financial firm LPL, companies are going to have a hard time eliminating enough expenses to hit earnings targets. "When there's no more fat to cut," he says, "you start to cut muscle, and then you're cutting bone."

The problem with these views is they rest on the belief that companies are revenue-challenged. That may be true for some companies over the past few quarters. But it simply isn't true overall.

Since 2009, while the global economy has grown less than 4 percent per year, on average, companies have generated revenue growth at almost twice that rate. As for companies engaged in the more dynamic areas of our economic lives ‑ technology companies, innovative retail companies, industrial companies ‑ those have grown at an even faster clip. What's more, the average rate of growth is weighed down by financial companies‑ though overall that is a good thing, given how bloated and outsize the financial industry had become before 2009.

Presented by

Zachary Karabell is Head of Global Strategy at Envestnet, a financial services firm, and author of The Leading Indicators: A Short History of the Numbers that Rule Our World. More

At River Twice Research, Karabell analyzes economic and political trends. He is also a senior advisor for Business for Social Responsibility. Previously, he was executive vice president, head of marketing and chief economist at Fred Alger Management, a New York-based investment firm, and president of Fred Alger and Company, as well as portfolio manager of the China-U.S. Growth Fund, which won a five-star designation from Morningstar. He was also executive vice president of Alger's Spectra Funds, which launched the $30 million Spectra Green Fund based on the idea that profit and sustainability are linked. Educated at Columbia, Oxford, and Harvard, where he received his Ph.D., he is the author of several books, including Superfusion: How China and America Became One Economy and Why the World's Prosperity Depends on It (2009), The Last Campaign: How Harry Truman Won the 1948 Election, which won the Chicago Tribune Heartland Award, and Peace Be Upon You: The Story of Muslim, Christian, and Jewish Coexistence (2007), which examined the forgotten legacy of peace among the three faiths. In 2003, the World Economic Forum designated Karabell a "Global Leader for Tomorrow." He sits on the board of the World Policy Institute and the New America Foundation and is a member of the Council on Foreign Relations. He is a regular commentator on national news programs, such as CNBC and CNN, and has written for The Wall Street Journal, Newsweek, Time, The Washington Post, The New Republic, The Los Angeles Times, The New York Times, and Foreign Affairs.

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