Profits’ share of national income is very volatile over the business cycle because it reflects the volatility of its two determinants that also fluctuate with the business cycle, namely revenues and the profit margin.
The latter is the more volatile of the two and is highly correlated with profits’ share of national income. It has the same cyclical pattern as profits’ share of national income. They both rise rapidly during recoveries and expansions when revenues tend to rise faster than costs, which boosts the profit margin. They both tend to peak and fall near the tail end of expansions when costs, including payrolls and capital spending, start to outpace revenues. During recessions, profits plunge on an absolute and relative basis as revenues fall faster than costs, which also depresses profit margins.
The jury is still out on whether the profit margin has peaked, having risen to a record high of 10.4% during Q1 for the S&P 500. That will depend on whether companies will raise wages as they continue to expand their payrolls. It will also depend on whether the pace of capital spending picks up. So far, there’s not much evidence that these costs are taking off.
However, the profit margin can also get squeezed if revenues growth slows, which does seem to be happening. That’s because global economic growth is lackluster. On Wednesday, the Organization for Economic Cooperation and Development lowered its forecast for world economic growth to 3.1% this year and 3.8% in 2016, down from its prediction six months ago of 3.6% and 3.9% growth, respectively. Furthermore, revenues growth has been hard hit by the drop in oil prices and the strength in the foreign-exchange value of the dollar since last summer.
Source: Ed Yardeni — Ed Yardeni is the president and chief investment strategist of Yardeni Research Inc., a provider of independent investment strategy and economics research for institutional investors.
