Corporate America is well prepared for the coming storm

Globe and Mail

2 days ago

Headwinds from tariffs, bond yields and 'stagflation' are gathering force, but corporate America could not be in better shape to face the economic storm that may be building.
Data released last week showed that U.S. pre-tax corporate profits fell US$118.1-billion, or 2.9 per cent, in the first quarter, the fastest pace since 2020, suggesting companies are feeling the pinch from tariffs even before they've properly started to bite. After-tax profits fell 3.6%.
But any sense of alarm should be mitigated by the fact that profits surged US$205-billion, or 5.4 per cent, the three months before. The decline in the January-March period was simply normalization on the back of a bumper quarter.
And on a year-on-year basis, profits were up more than 5 per cent.
True, the next few quarters could get messy. If growth slows or inflation starts to rise, corporate margins could get squeezed, consumers may curb spending and companies could find themselves with limited pricing power.
But zoom out, and the bigger picture suggests corporate America has rarely been stronger.
Depending on how you slice and dice the figures, corporate profits as a share of national output or income are still extraordinarily high. In some cases, they're close to the highest on record.
Consider pre-tax profits with inventory valuation and capital consumption adjustments. These fell slightly to 13.0 per cent of GDP in the first quarter of this year, on a seasonally-adjusted annual basis, but that was from a record 13.5 per cent in the September-December period.
After-tax profits dipped to 12 per cent of GDP from 12.2 per cent in the final quarter of last year. Again, that was a small decline, and it leaves after-tax profits still near the all-time peak of 12.8 per cent of GDP recorded in the second quarter of 2021. The average over the past 75 years is less than 7.5 per cent of GDP.
To paraphrase former British Prime Minister Harold Macmillan, corporate America has never had it so good. Which is just as well, because headwinds are gathering.
One can debate how much any of the number of brewing risks will land on the real economy, but companies could certainly feel some pain if they end up facing the collective punch of tariffs, weakening consumer demand, diminishing pricing power and higher-for-longer interest rates.
'An increasingly fragmented environment means diverging trends across economies. It's an environment ... that will constrain profits at home and around the world,' says Gregory Daco, chief economist at EY-Parthenon.
Tariffs and protectionism will put the squeeze on global supply chains and overall trade. It will be interesting to observe how the divergence between domestically-generated profits and earnings accrued from the rest of the world (RoW) plays out in this environment.
Domestic profits account for the majority of total income, of course, but that share has exploded recently. Or looked at the other way, the share of profits from abroad has plunged. If Trump's trade war succeeds in prompting U.S. companies to bring more production back home, the 'RoW' footprint may shrink further.
In the fourth quarter of 2019, just before the pandemic, domestically-generated profits were around 75 per cent of the US$2.13-trillion total, on a seasonally-adjusted annual basis, and 'RoW' profits accounted for a quarter. In the first three months of this year, domestic profits accounted for 87.5 per cent of the total, and the share of profits from abroad had halved to 12.5 per cent.
Corporate profitability is being tested. The aggregate second quarter earnings growth forecast for S&P 500 companies stands at 5.5 per cent, according to LSEG I/B/E/S, down from 10.2 per cent two months ago. The 2025 calendar year earnings growth forecast has shrunk to 8.3 per cent today from 14.0 per cent at the start of the year.
The challenges are mounting, but corporate America can face them from a position of strength.
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