On March 23 of last year, at the start of the coronavirus pandemic, the S&P500 briefly traded below 2,200. Since then, it has more than doubled, surfing on a wave of corporate profits, in a sea of central bank liquidity. However, investors should recognize that this wave will face challenges going forward while the tide of monetary easing should turn. As this happens, a focus on valuations should be more rewarding than has been the case in recent years.
This Thursday, the Bureau of Economic Analysis will release revised GDP numbers, along with its preliminary assessment of corporate profits for the second quarter. The next day, Federal Reserve Chairman, Jerome Powell, will speak virtually to the Annual Jackson Hole conference.
Investors around the world will, of course, pay much closer attention to the second of these events than the first. Any indication on when and how the Fed may begin to taper its massive bond purchase program could have significant and immediate impacts on global financial markets.
However, it is also worth looking closely at the profit numbers and how they were achieved. The GDP accounts provide a particularly useful snapshot of the entire picture, including compensation costs, corporate taxes, depreciation, rent and net interest. This allows us to look at after tax profits from the top down—as the last slice in a big national income pie. One way for profits to grow is for the pie simply to expand. Another is for the profit slice to expand at the expense of the other slices. Both of these phenomena have been on full display in recent years and we expect after-tax profits to set a new, all-time record in the second quarter, mirroring the performance of S&P500 operating earnings. The question is: can this profit surge be sustained?
The first issue is the size of the pie itself. While from an accounting perspective, profits are part of national income, the growth of national income is very closely tied to the growth in nominal GDP. We expect revised data to show nominal GDP rose by 16.9% year-over-year in the second quarter, in a dramatic bounce-back from a deep recession a year earlier. Powered by continued reopening activity, inventory rebuilding and some further fiscal stimulus, we expect nominal GDP growth of a still very strong 9.3% over the next year. However, in the following year, that is between the second quarter of 2022 and the second quarter of 2023, nominal GDP growth could fall to 5% or less, as economic growth is severely constrained by limited labor supply and potentially divided government after the mid-term elections shuts down further Washington aid.
Consequently, even if the economy avoids a recession over the next few years, the national income pie is likely to grow much more slowly. But how about the relative size of the slices?
The most important slice is employee compensation, which fell from 57% of GDP in 2000 to 52% by 2011 but which has since risen to 54%. Over the next year, even with hourly wages growing at an annual pace of close to 5%, a lack of available workers in a surging economy will likely continue to result in strong productivity growth and the compensation share of GDP should drift down. However, in the following year, as growth slows in an economy with very tight labor markets, compensation should grow faster than the economy overall.
Interest and rental costs should also remain low in the year ahead as companies are able to take advantage of locked-in lower bond interest rates and low-priced lease agreements from the pandemic. Depreciation expense should also remain low, reflecting a 5.2% drop in business fixed investment last year. However, these expenses also should drift up in 2022 and beyond.
Corporate tax expense should also move higher in 2022. While considerable uncertainty surrounds the reconciliation bill, which the Administration is hoping to push through Congress this fall, it is likely to increase the statutory corporate tax rate to at least 25% from its current 21%. In 2019, before the onset of the pandemic, the effective average corporate tax rate was 12.8%. Extrapolating from the impacts of the 2017 corporate tax cut suggests that boosting the corporate tax rate to 25% could add about 2 percentage points to this effective tax rate in 2022 and beyond.
Corporate profits also generally benefit from a falling dollar and rising oil prices. In the second quarter, the broad trade-weighted dollar was down 8.2% year-over-year while the price of a barrel of West Texas Intermediate Crude Oil was up 135%. Neither of these variables should be a major factor in boosting or dragging on profits over the next year.