U.S.: Get Ready for Rebounding Profits

Cost-cutting and a surge in productivity will lead to rosier earnings

The economic surprises just keep on coming. The latest bit of good news is from the labor markets: Payrolls in February posted their first increase in seven months, and the unemployment rate edged lower--not higher, as was widely expected. Moreover, fourth-quarter productivity rose at the fastest rate in a year and a half. That's not supposed to happen during a recession.

The message is clear: The economy is gaining ground on several fronts. Steadfast consumer spending will continue to pull manufacturing out of its slump; productivity gains will help businesses cut costs, laying the groundwork for renewed profit growth (chart); the improving outlook for profits and revenues will feed a pickup in capital spending; and the recent broad rise in commodity prices signals firmer global demand.

Consumers continued their spending ways in February. Retail sales increased 0.3% from January, and excluding the ups and downs in car buying, February sales rose 0.2%, after surging 1.2% in January. Although auto sales will subtract from overall consumer spending in the first quarter, strong demand elsewhere means that consumer outlays are growing at an annual rate of at least 2%. A month or two ago, economists had expected consumer spending this quarter to drop.

But the real story for 2002 is in the labor markets, and it's not just their surprisingly upbeat showing in February: They are telling us that, because businesses are keeping productivity up and costs down, the outlook for profits is a lot better than you might think. Job-market improvement this year will very likely come slowly, and the jobless rate may even pick up again, although not by enough to slam consumer confidence or spending. But that's a reflection of businesses' strategy to lift their bottom lines--a strategy that will add momentum to the overall recovery because it will help to drive future growth in capital spending.

AGGRESSIVE COST-CUTTING and swelling productivity are already starting to pay off for many businesses. Don't look for the benefits in company earnings reports. It's not there yet, but it will be. For example, the Commerce Dept.'s roundup of fourth-quarter profits, to be reported on Mar. 28, will likely show that economywide operating earnings of companies large and small rose from the third quarter.

Commerce seasonally adjusts earnings so that quarter-to-quarter comparisons are meaningful, and it standardizes reports from some 5,000 companies, especially with regard to inventory values and depreciation allowances. Although Commerce's accounting always lags behind the typical quarterly earnings reports, it is actually a more consistent and broader measure of corporate profits. Based on a Federal Reserve estimate of Commerce data, fourth-quarter operating earnings rose 6.9% from the third-quarter level.

Although that would still leave this measure of earnings more than 12% below the fourth quarter of 2000, the point here is that profits are already turning the corner. That's because the fourth quarter's 5.2% jump in productivity more than offset the quarter's 2.3% advance in compensation, resulting in a steep 2.7% drop in unit labor costs. By definition, when prices increase faster than unit costs, as they did during the fourth quarter, profit margins rise.

It was not just a one-quarter fluke: Productivity is set to post another sizable advance in the first quarter. The February job report says that hours worked this quarter are below the fourth-quarter level. That means any increase in gross domestic product will translate fully into productivity growth, and current expectations for real GDP are in the 3% to 4% range. Since compensation is slowing, there will be another sharp drop in unit labor costs, perhaps adding up to the largest two-quarter decline since 1983. The upshot is another boost for profit margins.

CORPORATE AMERICA'S PUSH for profitability will continue to scramble job growth in coming months. To be sure, February's 66,000 increase in payrolls was good news, following losses averaging 240,000 per month since September. Service-sector payrolls increased for a second consecutive month (chart), and even temporary workers posted a gain after months of large losses, a sign that many businesses are looking for extra help. Manufacturing payrolls fell by 50,000, but that was the smallest decline since December, 2000.

Still, the February gains were meager. Typically, overall payrolls must increase by about 150,000 per month just to keep the unemployment rate from rising further. If the economy grows 3% to 4%, that pace will be achievable in coming months, but the drop in the unemployment rate--to 5.5% in February, from 5.6% in January and 5.8% in December--is inconsistent with the recent weak pace of job gains.

Right now, the Labor Dept.'s count of payrolls, taken from a survey of businesses, seems to be a more reliable yardstick for the job markets than Labor's survey of households, from which the jobless rate is derived. The recent dip in that rate may reflect quirks in the data, which have been exceptionally volatile recently. The February household survey showed one of the largest monthly jumps in employment on record--hardly believable--along with unusually large ups and downs in the labor force since December.

FUELED BY PRODUCTIVITY GAINS and cost-cutting, a turnaround in profits will allow businesses to increase their capital spending as demand picks up. Thanks to record cutbacks in outlays last year and inherently faster depreciation of tech equipment, some excess production capacity has been reduced (with the exception of telecommunications equipment). Plus, sharp declines in interest rates have created better financing conditions, even as companies have reduced their need to tap into the credit markets.

For example, the corporate financing gap--the amount by which capital expenditures exceed companies' internally generated funds--has narrowed enormously. It's down to its lowest level since 1997, according to estimates by the Federal Reserve (chart). That implies less pressure on companies to seek outside financing for new projects. As a percentage of capital spending, the gap has been cut from about 30% a year ago to about 15% by the end of last year. Improving profits and cash flow will shrink the gap even further this quarter--even as lower borrowing costs make outside financing more attractive.

Of course, the proof is in the pudding, which in this case is the bottom line. It's not there yet, but better news on earnings may well be the economy's next surprise. Watch for an increasing number of earnings reports that beat expectations as first-quarter numbers come out. If that starts happening, it's another important sign that this recovery is on solid ground.

By James C. Cooper & Kathleen Madigan

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