Profits Boom, Igniting Investment

Corporate earnings are soaring, fed by the highest margins on record. This is driving a surge in business spending on capital equipment

By Michael Englund

Happy days aren't just here again. They may be hanging around awhile, predict economists from research outfit Action Economics. U.S. corporate profits posted powerful second-quarter gains, and solid third-quarter figures are expected as well. The profit boom in this cycle has been unusually large and has fueled a solid investment boom that's strong even relative to the previous expansion.

Continued strength in profits through yearend should keep the investment boom alive well into 2006. That bodes well for economic and financial-market performance in the coming months.


  The BusinessWeek survey of corporate profits and sales of 900 companies each quarter provides a suitable dataset of figures that can be used before the release of the official corporate-profit figures. Both sales and earnings from the BusinessWeek survey have experienced a powerful run of strong increases (see BW, 8/22/05, "Sticking to the Sweet Spot"). Profit gains on a year-over-year basis have been double-digit for 10 consecutive quarters, and sales growth has been double-digit for seven quarters.

BusinessWeek also reports that profit margins, at 7.9%, are the highest on record, which extends back to 1973. The BusinessWeek data are more volatile than the government's corporate-profit data, but they generally track well.

The trend for the BusinessWeek data shows a stable and robust expansion trajectory around the most recent 20% growth clip in the second quarter, despite the moderation in gains for the official quarterly profit data. At Action Economics, we expect this gap between the two measures to close over the coming quarters, as year-over-year after-tax profit increases climb to a 9% pace in the second quarter and a likely 15% clip in the third. Profits are rebounding due to strength in gross domestic product(GDP) relative to personal income -- this is clear in the pattern of outperformances and boosts to guidance through the most recent earnings season.


  As we frequently note, year-over-year growth in profits is closely correlated with year-over-year increases in gross nonresidential investment in the GDP reports, even though efficient capital markets would argue against this otherwise close relationship. The expected bounce in corporate-profit growth over the coming quarters bodes well for the investment outlook, as increasingly abundant cash flow at businesses loosens the reinvestment purse strings and feeds the current robust trajectory for capital-equipment orders. This should help boost the persistently restrained recovery in the commercial construction industry.

Gross investment in the second quarter was held back by the sharp second-quarter freefall in business inventories, which left this measure at only 2.7% year over year. This occurred despite 11.1% year-over-year growth in "fixed" nonresidential investment, which usually dominates the trend. The bounce we now expect in inventories should bring these year-over-year growth figures back quickly to the 6% area in the third quarter, 7% area in the fourth quarter, and the 10% area by second-quarter 2006 as the data benefit from easy comparisons.

On an annual basis, nonresidential fixed-investment growth reached 9.7% in 2004 and is on track for another 9% rise in 2005. These increases are both in line with the largest of the jumbo gains seen in business fixed investment through the 1992-2000 investment boom. This investment cycle will experience "extra" support from the $350 billion in repatriation underway this year that must be invested to qualify for preferred tax treatment, due to the American Jobs Creation Act passed last year.


  Recent investment strength is also being driven by much more accommodative fiscal and monetary policies this time around. This remains the case despite the tightening trajectory in Federal Reserve policy that will simply close the gap over the coming year between an accommodative policy and a "neutral" one by the fifth year of this cycle. This development occurred during the fourth year of the 1991-2000 business cycle -- and proved to have notably little impact on an otherwise robust investment boom despite having a restraining effect on GDP growth in 1995.

Finally, inflation-adjusted final sales are actually accelerating through the most recent quarter of this expansion at a more impressive rate than seen in the last cycle. This may also reflect the more stimulative effects of fiscal and monetary policy through this cycle, and repatriation.

But the trend is probably also being fueled by the powerful profit cycle underway for domestic operations. This steady acceleration in real spending growth has shown little negative reaction to the series of increasingly high spikes in energy prices, which the markets keep expecting will eventually temper U.S. and world growth in aggregate demand.


  Overall, U.S. corporate-profit growth is experiencing a robust boom in this cycle that's showing little sign of abating. Similarly, gross business investment is in the middle of what appears to be a powerful increase that's strong even in comparison to the boom years of the last technology-led expansion. This uptrend in both profits and investment is being fueled partly by the unusually accommodative fiscal and monetary policies in this expansion, as well as repatriation.

With corporate profits poised for healthy gains through the third quarter -- and likely through the fourth quarter -- it appears quite probable that business investment will remain robust as well.

Englund is chief economist for Action Economics