Why corporate profits are soaring as economic recovery drags

U.S. corporations continue to post strong profits quarter after quarter, even as the unemployment rate remains high and the economic recovery plods along in fits and starts. What gives?

Corporate profits grew 36.8% in 2010, the biggest gain since 1950, according to Friday’s latest report from the Bureau of Economic Analysis. No sign could be more clear that U.S. companies see the recession in the rearview mirror.

The strong profits, however, mask the continued difficult terrain for businesses. Yes, profits are high, but that doesn’t mean business is strong.

“It’s not that they’re fake; it’s that they’re generated through a bunch of economic anomalies that are not the normal course or normal factors that generate profits,” said Martin Regalia, chief economist for the U.S. Chamber of Commerce, the premier business lobby.

Regalia and other analysts think several factors are behind the strong profits, which seem to contradict other indicators of an underperforming economy, especially the 8.9% unemployment rate. These factors include record low interest rates since late 2008, muted demand for borrowing by companies and a surge in productivity that has allowed companies to do more with the same number of workers or fewer.

Profits aren’t rising solely because companies are making and selling more widgets to keep up with customer demand, which would be the case in a healthy, booming economy. Instead, they’re companies are more profitable because it now costs less to make the same widget, often because far fewer workers are needed to make it.

“We’ve been able to generate record profits on very, very low volume and very weak economic growth,” Regalia said.

That’s not to say things aren’t improving. Over the last six months, the economy has gathered steam, and demand is picking up — as seen in factory orders for parts needed in assembly, a rebound in automotive manufacturing and rising consumer purchases.

That’s a healthy growth trend, but the bigger part of the story remains workforce reductions, technological advances, low lending costs and minimal borrowing. All have combined to give companies unusual control over their balance sheets and thus their profits.

“If you are looking at where profits are coming from … cost control, strong capital discipline, strong control over the balance sheet — that’s why you’ve seen this extraordinary recovery in profits, even though top-line growth hasn’t been spectacular,” said Aaron Smith, a senior economist at Moody’s Analytics.

Another factor in today’s strong corporate profits also might mask how sluggish the U.S. recovery has been — the growing percentage of profits from foreign sales by U.S. corporations.

That number climbed steadily over the last decade and peaked at 45.3% in 2008. That underscores how globalization has made it harder to define winners and losers. Americans are wrestling with high unemployment, but overseas sales have boosted U.S. corporate profits. That in turn lifts the stock market, which lifts the wealth of workers with 401(k) retirement plans and company shareholders alike.

“Earnings from abroad have become more important to U.S. companies. That trend has been in place for a couple of decades now, but really in the past decade we’ve seen the share of earnings coming from abroad as a share of the total increase rather dramatically,” Smith said.

Whatever the reasons, there’s no getting around the fact that profits are super-sized.

“The profits recovery during the past two years is among the best, if not the best, ever. Profitable companies expand. They hire workers, buy equipment and build more plants and offices. Capital spending on equipment has been recovering along with profits. It is up 18.6% over the past six quarters. Employment gains have been lackluster, but are picking up,” Ed Yardeni, a veteran market analyst, wrote in a recent upbeat note to investors.

For now, one question remains: When do increases in corporate profits actually translate into hiring? Traditionally, profits lead hiring in an economic recovery.

“Normally, profits lead by a couple of quarters both job creation and capital spending. They’ve been leading this time. We’ve had job growth, but it just hasn’t been as much as we might like,” said Richard Rippe, an economist with ISI Group Inc., who added that employment and capital spending are both up. “It looks like the normal dynamics are working, but it would be good if they were working a little more decisively.”

Hall writes for McClatchy Newspapers.