Profits Now, Jobs Later: Call It The Trickle Down Recovery

On Mar. 30, two disparate headlines popped up on the newswires. According to one, business optimism for sales and profits is on the rise. The other said consumer confidence in the outlook falls for the third month in a row. Which one has the right story?

Both. This tale of two sectors highlights an important dichotomy that has made this two-year-old expansion the mediocre affair that it is. Household incomes aren't growing as they should be, because companies are hiring cautiously. At the same time, corporate earnings are doing quite well, thank you, because companies are squeezing more output from each worker and saving on labor costs (chart). The real question is, how will this split affect the outlook for the rest of 1993?

For one thing, rising profits are shoring up corporate finances and laying the groundwork for more capital spending, stronger demand generally, and more jobs. Hiring in recent months already has picked up from its paltry pace of a year ago. This spring, manufacturers and builders are poised to make significant additions to their payrolls. However, corporate restructuring is an ongoing affair that will keep overall employment growth below that of a typical expansion.

That doesn't mean consumers will be left to eat cake. So far in the first quarter, both household income and spending have slowed from their rapid fourth-quarter paces, but the slowdown is far from a stall. For the rest of 1993, slowly improving labor markets, combined with lower long-term interest rates, will further bolster household finances. That will keep consumers buying, despite the recent souring in their attitudes.


It's easy to see why the mood of Corporate America is a lot more upbeat than that of Household America. Look at profits. The Commerce Dept.'s comprehensive roundup for the fourth quarter of 1992 shows that book profits before taxes rose 10.8% from the third quarter. Operating profits jumped 15.3%.

The quarterly gain in operating earnings, which are adjusted for inventory inflation and depreciation differences between tax and replacement-cost accounting, was the largest in nearly eight years. That's partly because third-quarter earnings were depressed by hurricane losses in the insurance industry. Still, operating profits stood 23.4% above a year ago, the best year-over-year performance in nearly five years.

The outlook for corporate profits in 1993 looks just as good, if not better. A lot depends on the economy--specifically, whether growth this year will at least match last year's pace of 3.1%. The signs are favorable. The index of leading indicators, a composite of 11 forecasting gauges, rose 0.5% in February. After no gain in January, that was the fifth advance in the past six months.

Also, businesses seem increasingly optimistic, according to the latest nationwide survey of some 3,000 executives by Dun & Bradstreet Corp. Business expectations for higher sales and profits in the second quarter are well above both last-quarter levels and year-ago readings, says D&B, and companies hold the brightest outlook for increased hiring since the third quarter of 1989.

That job outlook squares with the most recent reading of the Conference Board's index of help-wanted advertising. The index jumped from 92 in January to 98 in February, the highest tally in slightly more than two years.

Manufacturers are especially confident, says D&B, and their optimism seems justified. The latest factory data show that orders jumped 1.4% in February, to a record $258.6 billion. Inventories, which edged up by 0.1% in the month, remain very thin relative to shipments. And unfilled orders rose 0.3%, the fourth increase in the past five months, following a string of 13 consecutive declines (chart). This configuration of data typically precedes gains in factory output and employment.


But it's not just the improving economy that will lift profits this year. Companies also are benefiting from lower interest rates that are rapidly easing the drain on cash flow that had been needed to cover interest costs on corporate debt. And not only are profits rising, but profit margins are also widening. That means companies are earning more on each unit of output.

In the fourth quarter, operating profits of nonfinancial corporations as a percentage of their output jumped to 9.8%. That's up from 7.4% when the recession ended, back in the first quarter of 1991. In fact, during that time, the rise in margins alone accounts for $75.7 billion of the $93.5 billion rise in the earnings of these companies.

Businesses are generating more profits per unit for two main reasons. First, since the recession ended, net interest paid by nonfinancial businesses has dropped by $15 billion, to $130.5 billion in the fourth quarter. As a result, interest as a percentage of net cash flow has fallen from a postwar record of 31.7% to 23.2%. That's the smallest interest burden in nearly seven years.

The second reason why margins are fatter: Even with diminished pricing power in a low-inflation environment, prices still are rising considerably faster than unit labor costs. During the past year, the average price of a unit of gross domestic product is up 3%, but the labor cost of producing that unit rose a mere 0.4%. The growth of unit labor costs has slowed from an annual pace af more than 6% two years ago--much sharper than the slowdown in prices.

The good news for 1993 is that unit labor costs will continue to rise only modestly. Corporate restructuring will limit the growth of wages and benefits, and it will also keep productivity growing at a healthy clip, sufficient to offset any pickup in wage growth. Add it all up, and the outlook for earnings in 1993 seems bright enough to justify the recent strength in stock prices.


Clearly, households don't share businesses' excitement about the future. The Conference Board's index of consumer confidence fell from 68.5 in February to 62.6 in March, the third drop in a row (chart).

The board's survey showed that households were less positive in their assessment of prevailing conditions, and they were markedly less optimistic about their expectations during the next six months. Jobs remain a prime concern. Six times as many people characterize jobs as "hard to get," compared with those who think "jobs are plentiful." President Clinton's tax plans also may have rattled some households.

Consumer confidence, however, has had a wobbly record of four ups and downs over the past three years, a pattern that has not always accurately reflected the spending behavior of consumers. This could be one of those times.

Real consumer spending rose a sturdy 0.3% in February. True, heavy outlays to utilities, reflecting the month's unusually cold weather, helped the numbers. However, first-quarter spending remains on a high plane compared with the fourth quarter, when outlays surged 5.1%, at an annual rate. Even if March spending is flat, outlays this quarter would rise at a 3% annual rate (chart). That wouldn't be too shabby following such a huge gain, and consumer spending is two-thirds of GDP.

Even personal income was a bit better than it looked in February. It rose only 0.2%, but the gain was held back by a one-time payout of bonuses in the securities industry in January. That made the February level look pale by comparison. Excluding the special factors, Commerce said income would have risen by a healthier 0.5%.

Adjusting for inflation, aftertax income is set to rise at an annual rate of 2% or better in the first quarter. That would follow a fourth-quarter jump of 4.3%, which was the strongest quarterly gain in almost five years.

To be sure, such numbers portray neither the worst of times for consumers nor the best of times for businesses. But one thing is looking increasingly clear: 1993 is shaping up to be a better time for everyone.