The Economy Is Revving And Profits Are Set To Take Off

The profit slump is over. A growing number of economists, whether of the anemic-recovery school or the strong-rebound camp, are confident that as the economy snaps back, a double-digit corporate earnings rebound isn't far behind (chart). "We expect corporate earnings will rise at a 20% annual rate during this year's second half," says Mark Zandi, economist at Regional Financial Associates Inc. Adds Edward F. McKelvey, senior economist at Goldman, Sachs & Co.: "Corporate profits may fall short of the traditional rebound of 30% to 40%, but they are going to be much better than many expect."

One reason the profit rebound may not match historical standards is that the downturn in profits was less severe than in most recessions. Pretax profits were down 4.2% in the first two quarters of the recession, compared with a 10.9% average decline during the last four recessions, says Stephen S. Roach, economist at Morgan Stanley & Co. On an aftertax basis, profits have done even better. These figures are for "economic" profits measured in the gross national product accounts, which are not the same as the profits reported to shareholders. Economic profits make adjustments to inventory and depreciation schedules as carried on company books to get a more exact picture of the overall trend in corporate earnings.

What accounts for the strength in profits? Overseas sales, for one. U. S. exports have been strong, even during the recession. For another, rigorous cost-cutting and savvy inventory management helped stay any earnings carnage. Corporate inventory costs, for example, currently account for only 12.5% of corporate cash flow, compared with more than 25% just 10 years ago, says RFA's Zandi.

Other economists add that business is holding a tight rein on labor costs. So as companies step up production to meet increasing demand, profit margins will widen, fattening the bottom line, says Goldman's McKelvey. Adding to the earnings optimism is the two-percentage-point drop in short-term interest rates during this recession. Since about half of all corporate debt matures in a year or so, lower rates could cut the corporate interest bill by some $15 billion over the next year. And as profits rise, corporate spending usually picks up, which in turn will reinforce the economy's upturn.

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