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We’re in the thick of another corporate earnings season and companies are once again reporting blowout profits.
Yet economies on both sides of the Atlantic are struggling. The U.K. and a raft of countries along the euro-zone periphery are in recession, economies at Europe’s core are weakening and even the U.S. is looking like it’s running out of steam.
How do you square the one with the other? Maybe by blaming general economic weakness on particular corporate strength.
And what strength. In the latest quarter, more than 80% of S&P 500 reporting companies have beaten earnings expectations. Profit margins are at historic highs even as the U.S. economy registers an unusually slow rebound from its deepest downturn since the Great Depression. The story’s similar in the U.K.
So what do profits have to do with slow recovery?
The link is the Anglo-Saxon bonus culture, according to Andrew Smithers, of Smithers & Co, an independent economic consultancy.
Roughly speaking, here’s the logic. The shift to profit-related pay, or bonuses, has turned the focus on to reported profits. In the U.S., these profits have, over the past decade, but particularly since the start of the recession, become six times more volatile than profits in the national accounts, having been no different before that time.
The drive to boost published profits has pushed down business investment in both the U.S. and the U.K. This has boosted the relative wealth of owners of capital compared to the rest of the population. Because the rich consume less than the rest, this has had a dampening effect on wider incomes and economic growth.
Only fiscal policy is able to maintain wider economic growth in this environment. Any shift to reduce deficits will prove a disproportionate drag on wider economic growth.
Of course, profit distortions don’t just work in one direction. At some point, the U.S. and U.K. corporate sectors will hit a bump. At that point, reported profits are likely to fall considerably further than those in the national accounts.
And as governments need to cut their deficits they will increasingly look to where the money is: corporates. Ultimately, this could force firms to rethink how they run their businesses, perhaps aiming more towards long-run returns rather than short-term profits.
Whatever happens, the era of high margins won’t last forever.
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The Source is WSJ.com Europe’s home for rapid-fire analysis of the day’s big business and finance stories. It is edited by Lauren Mills, based in London.
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