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

800 people over profit.jpg

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.

More important, while some companies are finding it hard to generate growth, over the past four years the sectors we would want to shrink are shrinking while the sectors that stand to materially improve our lives have been booming. Financial services, some healthcare companies, coal and oil producers - those are the industries that have been challenged. The shrinkage of these sectors is a good thing; you don't want healthcare costs eating up larger portions of national income (which remains a problem); you don't want energy costs crowding out other consumer spending; and you don't want a bloated financial services sector. Meanwhile, Google, Amazon, eBay, Apple, Honeywell, United Technologies, Netflix, Target and on and on ‑ those have thrived. And they're not thriving at the expense of society, whatever the rhetoric about inequality would suggest.

Yes, there is massive inequality, and average wages have stagnated in the United States and decreased in much of the developed world. But that is the average. Within that, wages for the college-educated, for the skilled and for residents of dynamic urban areas have been growing rapidly and robustly. Google would not be generating almost $60 billion in revenue this year unless millions of businesses large and small were using banner ads and search to expand their businesses, and they can only spend that money because their businesses are, in fact, expanding. EBay is growing at double-digit rates because PayPal is booming, and it wouldn't be booming without those millions of consumers using it for payments.

How we view corporate earnings is being distorted through various negative lenses. One lens says macroeconomic growth defined by GDP is slow and getting slower and companies are about to slow down far more than we think. Another lens says the relative success of companies is coming at the expense of substantial swaths of society. Neither lens allows for the fact that companies are doing well because vast swaths of the globe are booming, including substantial numbers of people not just in China and the emerging world but also in the United States. That boom isn't just a function of creative accounting and cost cutting. It's because so many are doing quite well in the world today even as many people struggle mightily.

The economies of today are simultaneously serving the needs of more people than ever while failing to provide sufficiently for vast numbers of people. That explains why so many companies are succeeding so spectacularly, and why that trend is likely to continue for quite some time. They thrive because many are thriving, and because they bear few of the burdens of states that must provide for those who are not thriving. Healing that split is one of the challenges of our day. Thankfully, the thriving companies are the ones are most likely to be part of those solutions.