America’s largest companies have just unveiled their earnings for the second quarter of 2022. As ever, the reporting season provided an opportunity to check the pulse of the top US companies and the economy more broadly.
The outcome suggests the US is at a crossroads, with the post-Covid rebound starting to fade. Retail giant Walmart warned that inflation is chipping away at the spending power of consumers, while Meta’s chief executive Mark Zuckerberg said that economic headwinds would have a ‘broad impact’ on digital advertising.
On the other side, Microsoft predicted double-digit revenue growth for the coming year as companies boost IT spending, and ExxonMobil and Chevron shattered profit records on the back of higher oil prices.
Corporate profits are coming from a position of extreme strength – especially in the US
Into the downturn
But taking a step back from the details, the big question for executives and investors is how well profits can hold up as the economy slows. Data suggests the downturn is already starting. Gross domestic product in the US has now contracted for two consecutive quarters – a popular (though outdated) definition of a recession. And in Europe, a further cut in gas supplies from Russia is raising the prospect of energy rationing and a slump in growth.
So how serious is the threat to corporate profits?
While the answer will vary by company, sector and region, the good news is that corporate profits are coming from a position of extreme strength – especially in the US. Various metrics show profitability at or near to record highs. Net profit margin, a critical benchmark for investors since it measures profit available to investors after tax, is at a peak of 13% for S&P 500 companies, close to double the level of the 1990s, according to the latest data from Refinitiv Datastream and FactSet.
Return on equity, a measure of profitability in relation to the investment of shareholders, looks even better at 20%, the highest level in a series going back to 1974. It also tops the 19% return on equity recorded in the mid-1990s and in 2000, both halcyon periods for US companies.
US earnings hold up
There are several structural reasons for this strength, suggesting that while profit margins will tighten as the economy slows, US earnings overall should hold up well.
First, industry concentration appears to have grown. A study, Are US Industries Becoming More Concentrated?, published just prior to the Covid pandemic, concluded that more than 75% of US industries had consolidated since the late 1990s. Co-author Gustavo Grullon, professor of finance at Rice University, said this consolidation had become a major driver of profitability. ‘Firms in industries with the largest increases in product market concentration show higher profit margins and more profitable mergers and acquisitions deals,’ the report concluded. ‘Taken together, our results suggest that market power is becoming an important source of value.’
So far, the relative resilience of US earnings suggests that more US companies are able to pass on rising costs to consumers, with 73% of companies by market capitalisation exceeding their profit forecasts for the second quarter.
Apple, Microsoft, Alphabet, Amazon and Tesla account for 24% of the market capitalisation of the S&P 500
Second, the mix of industries in the US has contributed to historically elevated margins. Over the past few decades, large technology firms have come to dominate the S&P 500. Apple, Microsoft, Alphabet, Amazon and Tesla accounted for 24% of the market capitalisation of the index as of 1 August, with a value of US$8.4 trillion, versus the index total of US$34.7 trillion. Compare this with 1999, prior to the rise of the giant tech stocks, when S&P 500’s top five companies (including such capital-intensive businesses as Exxon, Walmart and General Electric, along with Cisco and Microsoft) made up just 17% of the index. Overall, the tech-focused companies are capital-light, high-margin businesses when compared with their old-economy predecessors. Overall, tech now accounts for 37% of the S&P 500, compared with just 7% for industrials and 4% for energy.
It is notable that tech businesses make up a far lower 11% of the Stoxx Europe 600 index. In fact, six other sectors rank above technology. And the tech portion of Stoxx Europe doesn’t boast the dominant global giants that are a key component of the US index.
This helps explain why returns on equity in Europe are a more modest 13% as opposed to 20% in the US. Nor is this exceptional by historical standards: returns on equity topped 17% prior to the global financial crisis and hit 15% in the 1990s.
Finally, after-tax profits in the US got a further boost in 2017 by a landmark reform of corporate taxation. This reduced the top corporate tax rate from 35% to 21% – a 40% reduction. Prior to the reform, US companies had a powerful incentive to shift profits to lower tax jurisdictions, including by housing intellectual property outside the US. Following the 2017 reforms it has made less sense to do so, and so US companies have registered more of their profits in their home market.
Of course, none of this means that margins can remain at current levels through the downturn. Even the top tech companies are taking steps to minimise the impact, by slowing or freezing new hires. In its second quarter earnings release, Amazon disclosed it has about 100,000 fewer employees than in the previous quarter, while Apple said it also planned to slow hiring.
Companies with weaker market positions or in more exposed sectors will surely need to take more aggressive action to protect margins. But for the US as a whole, companies are at least entering the slowdown from a position of historic strength.