All Access Week – Corporate Profits

At Prometheus, we are committed to equipping our clients with the most granular, high-frequency, and actionable understanding of macro conditions in the industry. We offer our clients a range of research solutions, from big-picture macro themes to actionable trading signals. In the spirit of giving back to the community, we are excited to offer an All-Access week in our Institutional Services. Each day this week, we will unveil one product offering from our extensive Institutional Offering. If you’re interested in institutional access, please contact us at [email protected].

Welcome to The Observatory. The Observatory is how we at Prometheus monitor the evolution of the economy and financial markets in real time. The insights provided here are slivers of our research process that are integrated algorithmically into our systems to create rules-based portfolios.

Our primary takeaways are as follows:

• The latest data on corporate profits increased sequentially and remain largely in line with future earnings expectations.
• Zooming in, we see pressures emerging from the major sources of corporate profitability i.e., household spending and contractionary revenue growth relative to interest expense.
• Nonetheless, currently these pressures remain muted and conditions remain fairly priced. In the context of markets, this top-line strength in corporate profits remains a support for stocks. 

Corporate profits include the reported earnings of both public and private companies and the aggregate profit backdrop, of which the S&P 500 occupies one part. As such, S&P 500 earnings expectations are largely a function of the ongoing trend in corporate profits. Below, we visualize the relationship between earnings expectations and corporate profits. As we can see, earnings expectations are largely consistent with profits but ahead in magnitude.

To further understand the ongoing profit impulse, we decompose the current profit trend into its six largest drivers by sector. Over the last year, profits have expanded by 10.14%. Below, we zoom out to show the 6 major drivers of strength in shades of blue (Utilities, Manufacturing, Wholesale Trade) and weakness in shades of red (Other, Retail Trade, and Information Technology). We visualize this below:

A crucial understanding of the nature of corporate profitability is that it is a zero-sum game. Profits enjoyed by corporations must be financed by one of three macroeconomic entities dissaving: households, governments, or foreigners. Alternatively, profits can be generated by businesses choosing to reinvest in aggregate. This understanding allows us to trace the sources and sustainability of current profit dynamics.

We begin this assessment with businesses’ own investments, which is the principal driver of profits over the long term. Over the last year, business investment has contributed 4.00% to the overall increase in corporate profits. Moreover, the recent sequential increase in business investment remains a support for corporate profits.

Next, we turn to the spending of households. Over the last year household spending has contributed 3.78% to corporate profits and the recent slowdown in household spending poses a challenge for corporate profits.

We move on to our tracking of the impact of government spending on profitability. Over the last year, government spending has contributed 9.85% to corporate profits. Moreover, government spending has sequentially decelerated which remains a headwind for corporate profits.

Finally, in our macro assessment of the macroeconomic sources of profits, we examine the contribution of net foreign spending to corporate profits. As we can see below, foreign spending has contributed -0.25% to corporate profits on a YoY basis and the recent trend remains a headwind for corporate profits.

Aggregating these dynamics from the sources of corporate profitability, Government Spending has been the dominant driver of corporate profits over the last year. Additionally, we observe pressures emerging under the hood. However, these pressures remain muted, thereby eliminating concern for a significant contraction in nominal conditions.

Now, while assessing the sources of profitability gives us some insight into the sustainability of current profit dynamics, monetary policy plays an equally important role. As shown previously, a significant part of business profitability comes from reinvestment. This investment is often levered and depends on the cost of capital. The path of monetary policy is the principal driver of the cost of capital over time. Below, we visualize the current change in monetary policy to understand its potential impact on corporate debt service costs. The current trend suggests that interest expense has sequentially decreased which is a tailwind for profits.

Finally, we examine how corporate interest expense changes impact revenue growth. To create this understanding, we examine the ongoing rate of nominal revenues relative to existing interest expense. The higher this number, the easier it is to service debt and increase borrowing, and vice versa. Currently, this data point is negative, i.e., interest expense growth has exceeded revenue growth. This remains a significant headwind for future profitability.

Overall, corporate profits remain largely in line with future earnings expectations at the top line. However, we observe pressures emerging under the hood from the sources of profitability and contractionary monetary policy. Nonetheless, in the current context, these pressures remain muted. Therefore, our assessment suggests that conditions are fairly priced today but may not be fairly priced tomorrow. In the context of markets, this top-line strength in corporate profits remains a support for stocks. Until next time.