U.S. Corporate Profits Rise to a record 11.1% of GDP 3/28/14

U.S. corporate profits hit new highs last year, driven by the tight lid firms have kept on hiring and spending almost five years into the economic recovery.  The closely watched measure of after-tax corporate profits rose to $1.9 trillion in the final three months of the year, the Commerce Department reported Thursday. Corporate profits stood at 11.1% of Gross Domestic Product (GDP), up a bit from the prior quarter.  The latest uptick underscored a factor that has dogged the economy since it emerged from recession, and is something we have been discussing for a while now: Many companies are guarding their cash rather than putting it back into the economy in the form of new hiring and are continuing to squeeze productivity gains out of existing workforces.  The 6% increase in corporate profits from the same period a year earlier comfortably outpaced GDP growth of 4.1% before adjusting for inflation. The latest GDP reading showed the economy was stronger in Q4 of 2013 than previously estimated ahead of weather-driven disruptions that have weighed on output in the early months of 2014.  The latest data shows that business are starting to pick up spending on equipment, hardware and acquisitions but they are not ramping up hiring yet.  We view corporate spending as one of the most critical indicators for the market in 2014.  It appears to us that business leaders are on the verge of “working around” the continued political dysfunction and may start deploying more capital in the months to come.

Declines in housing investment and government outlays were the two biggest drags on growth in the fourth quarter. Housing investment fell by 7.9%, less than the 8.7% drop previously estimated. It was the first annual decline in three years, triggered in part by rising mortgage rates.  Also, recent cold weather has further chilled home-building activity. Many economists still expect the sector to make a positive contribution to economic growth this year, though likely smaller than last year’s. 

Consumer spending, which accounts for roughly two-thirds of economic output, was the chief growth driver in the fourth quarter. Spending rose 3.3% in the fourth quarter, the fastest pace in three years. That was up from the previous estimate of 2.6% and from 2% in the third quarter.  Rising consumer spending underpins many analysts’ expectations for stronger economic growth this year, despite weather-related disruptions in the first two months. The fading effect of last year’s tax increases coupled with fast-rising stock and home values are boosting spending firepower.  However, retail sales fell sharply in January, though they partially recovered in February. Healthy consumer-confidence readings have buoyed hopes that many shopping outings have merely been delayed because of cold weather, though meager income growth could limit further spending gains in the months ahead.

Share Buybacks continue to be a Catalyst for the U.S. Stock Market:

Aggregate share buybacks showed no sequential growth in Q4, but grew 28.5% year-over-year to a level of $126.0 billion. Overall, S&P 500 companies have been more active during the trailing year than in any period since the financial crisis.  At the top of the index, IBM and Apple bought back shares amounting to $6.0 billion and $5.1 billion in Q4, respectively. Despite having not repurchased shares in the first quarter, Apple’s 2013 repurchases of $26.8 billion were the largest in the index by more than a 60% margin. However, Apple’s 2013 activity is not the largest trailing twelve-month tally of all time; Exxon Mobil repurchased $35.7 billion in 2008.  

In total, the 2013 share buybacks amounted to 3.1% of current shares outstanding in the S&P 500. Though this “buyback yield” also maxed out in 2007 at 4.9%, the metric was markedly higher during the four quarters spanning from Q3 2011 to Q2 2012 (see chart below). Part of the reason for the decline was due to the increase in stock valuations that make share repurchases more expensive and depress the number of shares purchased for a given dollar amount. The average trailing price-to-earnings (“P/E”) ratio of the S&P 500 was 12.9 from Q3 2011 to Q2 2012 versus 15.6 from Q2 2013 to Q4 2013.

Annual Federal Reserve “Stress Test” Results

The Federal Reserve released the results of their annual “stress tests” on Wednesday.  These tests are to ensure that the 30 largest bank holding companies have sufficient capital to continue operations throughout times of economic and financial stress, and to ensure they have forward-looking capital planning processes that account for their unique risks.  The main headline that came out of this was that Citigroup’s capital plan was rejected by the Fed and meant the bank could not increase its rewards to shareholders (i.e. bigger dividend, more buybacks).  The Fed was not concerned with Citi’s current capitalization, but rather did not approve of Citi’s proposed capital plans because they did not adequately estimate the impact a recession would have on their bottom line.  HSBC Holdings, Royal Bank of Scotland, and Banco Satander also were not “approved” to increase their shareholder rewards, despite the fact that, like Citi, they were deemed to be sufficiently capitalized.  Overall, the Fed is getting tougher on banks, requiring them to jump through more hoops, but their process does seem to be working.  By in large, most of these U.S. bank balance sheets are getting stronger.  Besides the four banks previously mentioned, only one other bank’s plans were not approved:  Zion Bancorp was deemed to be insufficiently capitalized.  And while the other 25 bank’s plans were approved, the Fed indicated they are still reluctant to allow aggressive capital plans in the future, instead preferring that the banks hold onto most of their earnings for now.


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