Tax rate cuts have masked an underlying deterioration in US corporate profits

The S&P 500 index has gained 23% since the beginning of 2019 driven mostly by the on-going easing of monetary policy by the Fed. This easing has supported the rise in the price-to-earnings ratio (P/E) as earnings per share over the same period has hardly moved.

Markets have, over the past 15 months, experienced some sharp reductions. Unless the Fed can implement a successful ’end of cycle’ policy this tailwind of growth is not likely to be sustained. Earnings will have an important role in determining equity returns as stock markets are driven by such fundamentals.

Data from the US Bureau of Economic Analysis shows that US corporations have been far less profitable than previously thought. The share of national GDP provided by pre-tax profits has fallen from 12.27% in 2014 to 9.9% in 2019. President Trump’s Tax Cuts and Jobs Act in December 2017 brought US corporation tax rates down from 35% to 21% masking an underlying deterioration in US corporate profits. The stimulus from these tax cuts is now beginning to fade.

Analysts are predicting that there will be a profit squeeze on US corporations due to increases in wages and that retail price rises are not likely to be high enough to offset rising labour costs. Therefore, earnings and profits are likely to suffer. Some fund managers are predicting a 3.7% drop in profits for 2019 and a 2.4% fall in 2020. Corporate profits will suffer further should the global economy fall into recession. However, it is possible that profits would improve if the US and China where to agree a trade deal and remove all tariffs. This would boost confidence, investment and trade volumes. Sadly, a comprehensive lifting of tariffs looks unlikely at this point in the negotiations but a start could be made soon.

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