Author: Richard Jerram, Chief Economist, Bank of Singapore, Member of OCBC Wealth Panel

Rising costs and weak productivity growth as the cycle matures pose an increasing threat to US corporate profits. Listed firms should be more resilient, but in the end will face similar pressures.

The impact of corporate tax cuts was already evident in the quarterly earnings of listed companies in 1Q 2018. Broader, GDP-based profit data show a similar pattern, but highlight a worrying trend of stagnating core profitability.

Pre-tax profit margins of listed firms usually lag the overall economy, because the index consists of more dynamic firms, with a global business and often in a monopolistic position to defend their earnings.

However, the divergence of the past few years is notable. Profitability fell in 2015 with the drop in oil prices, and it has since tracked sideways for the whole economy, unlike the rebound for listed firms.

For the overall economy it looks like rising costs – especially labour – are combining with the sluggish productivity growth that is typical of a mature economic cycle to put a squeeze on profitability. Firms will be trying to raise prices (which will worry the Fed), but still seem to be struggling with pricing power.

So far the situation is not too bad, but with unemployment below 4% we need to be alert to the danger of a decline in margins. Unsurprisingly, the share of national income being commanded by labour tends to rise and fall in line with fluctuations in the unemployment rate (albeit while on a long-term downward trend). This happens with about a two-year lag, so continued pressure on profits is already baked in.

It is important to note that economy-wide profitability usually starts going down well before a recession arrives. In recent cycles the profitability peak in 3Q 1997 was followed by recession in 2Q 2001; the 3Q 2006 peak preceded the 1Q 2008 recession. The profitability of listed firms is more closely aligned to the timing of recession.

The problem is that declining profitability adds to recession risk, as it tends to damage corporate investment and recruitment. This should be a fairly slow-moving story and is likely to be outweighed by fiscal stimulus for the next 18 months, but is another reason to be increasingly wary of a downturn in 2020 when it is likely to be alongside a more restrictive policy stance.