Watch Out for Falling Profits

As corporate earnings are pinched, prospects are dimming that companies will keep hiringfurther wounding consumers and the economy

With recession risks on the rise, all eyes are on U.S. consumers, but the focus should be on the business sector. Companies' decisions about whether to expand and hire in the coming months will mean the difference between an economy that stays afloat and one that sinks. The latest signs aren't good. Domestic profits are fading, and not just for sick financial companies. Financing options are more limited, and demand for new equipment and construction already look weaker. Although easy credit and fat home prices have boosted household spending in recent years, the most important fuel has been solid growth in both jobs and incomes. If businesses back away from expansion plans, the burdens consumers already face—costlier energy and tighter credit—will be much harder to handle.

Why worry? Corporate finances are taking a turn for the worse. Until now, companies have enjoyed high liquidity, low debt, and rivers of cash flow—all the key underpinnings of capital spending and hiring. Now profits are evaporating, credit is harder to come by, and productivity growth is not providing the same cushion it once offered companies to absorb rising costs. With pricing power weak, profit margins are getting squeezed.

Feeble third-quarter profits were bad news, but the government's economywide earnings data are worse. Profits from abroad, up 34.7% from the previous year, are propping up the numbers somewhat, and that's good. But earnings from operations at home are crucial to capital spending and hiring decisions in the U.S.

The growing weakness in domestic companies' bottom lines, even outside of finance, is striking. Despite solid 2.7% output growth at domestic nonfinancial corporations over the past year, their earnings have fallen 8.3%, the most since the last recession. After peaking in the third quarter of 2006, profits in this category, which account for half of all earnings, have been down from the previous year in each of the last four quarters.

A big reason is a squeeze on margins. The profit earned by U.S.-based nonfinancial companies on each unit of output fell to 12.8 cents last quarter from a record 14.3 cents the year before. Up to now, tight labor markets created solid gains in workers' income. But over the past three years, labor costs have picked up while nonfinancial productivity has slowed to 1.5% per quarter—less than half the pace of the three previous years. In short, pricing has not kept up with unit costs, lowering unit profits.

Therein lies the danger. Without the productivity advances of earlier years, companies may be quicker to squeeze payrolls to cut costs and shore up their bottom lines. Productivity posted a strong gain last quarter, but that pace won't last as the economy slows. Job growth has already cooled, and the government has revised this year's wage and salary income downward, suggesting job increases may be even weaker than the numbers now show.

The credit squeeze only compounds the problem of financing new investment. As of October, more banks had tightened their lending standards for businesses than at any time in nearly five years. And credit markets in November showed new strains as companies faced yearend funding requirements. Tougher loan conditions and weak profits make it harder for companies to justify capital outlays.

The latest soundings from the corporate sector are not reassuring. The CEOs in the Business Roundtable's quarterly survey seem to have taken the market turmoil in stride, but their overall outlook for sales, capital spending, and hiring remains near a four-year low. Government data show October orders for capital goods, excluding aircraft, dropped a steep 2%, nearly wiping out three months of gains. October outlays for business construction fell 0.5% after a year of increases. And in November new unemployment claims turned up notably.

The bottom line: Fading prospects for profits and growing pressure to cut costs could be the one-two punch that sends consumers—and the economy—down for the count.

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