Profit Margins Set to Reverse This Year

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Profit Margins Set to Reverse This Year By Smith Granade in West Chester February 4, 2005

Profit growth is set to slow over the course of 2005. The cyclical weakeningin productivity growth and subsequent rise in unit labor costs will be themain force underpinning this development. The current account adjustmentprocess and the decline in the dollar will provide a modest lift to margins.Economy.com expects profits to shrink to 6.8% of GDP in 2005, in contrastto 7.7% in 2004.

Margins, defined as after-tax profits as a share of GDP, exhibit a strongmean-reverting tendency: they have historically expanded at the end of recessions, then shrunk back and held steady at historic means asexpansions gather footing, and finally contracted again, falling below trend,toward the end of expansions. The first leg of this process has certainlybeen evident over the past few years. Growth in after-tax corporate profitsas a percentage of GDP, with inventory valuation and capital consumptionadjustments and excluding the more-volatile financial sector, soared torecord territory in the first quarter of 2004. After balance sheets wereravaged in the 20 01 recession, the corporate sector undertook aggressivecost-cutting efforts to restore balance sheets to their present health. Strongrevenue growth, coupled with robust productivity gains and low unit labor

costs have aided the substantial margin expansion over the past few years.But margins are set to shrink now as both fundamental and technicalfactors turn less favorable.

For one, the end of bonus depreciation incentives will be a source of downward pressure on margin expansion this year. Beginning in early2002, businesses were able to take an additional 30% bonus depreciationon new equipment or software, and an additional 50% in 2003 and 2004.The Commerce Department estimates that these tax incentives buoyedafter-tax profits by $65.3 billion (annualized) in the first quarter of 2004.This buoyed profit-margins for the quarter by 0.57%, according to our

measurements. As such, the lack of bonus depreciations should depressmargins by a similar degree in the first few quarters of 2005.

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A more fundamental factor is the productivity slowdown that is now under way. Slowing productivity results in higher unit labor costs; with margins soelevated, historical evidence suggests that rising unit costs will cut intoprofit margins rather than result in higher prices. Indeed, this cushionagainst price pressures is one reason for our sanguine inflation outlook. Wehave factored a slowing in productivity to a trend rate of about 2.3% and acommensurate decline in margins.

However, the risks are geared to the downside. Productivity generally tendsto fall below trend as cyclical boosts fade. A prolonged period below trendor, for that matter, a trend below our estimate would weigh heavily on profitmargins. Indeed, the recent data are somewhat concerning. Productivitygrowth showed a 0.8% (q/q annualized) increase in the fourth quarter, thesmallest quarterly advance in nearly four years. This continues the trendtoward slower growth that has been in place since the third quarter. Unitlabor costs rose 2.3%, and were up 1.0% from a year earlier.

Currency translation will provide a more modest boost to margins this year than last. Estimates indicate that the significant weakening in the dollar'svalue boosted profit margins only minimally over the past few years--anaverage of less than one-half of one percentage point since 2002.However, a stronger lift is quite possible this year, both because of further depreciation and lagged effects of earlier depreciation. (Note: Duringepisodes of dollar depreciation, the impact of higher costs of importedinputs on aggregate profits is typically more than offset by higher demandfor U.S. exports. Of course, the impact will vary by industry.)

All said, the outlook for profits this year will hinge on productivity and realcompensation growth. Faster-than-expected productivity growth and lower-


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than-expected compensation growth will be unambiguously beneficial for profit margins and inflation, and will have commensurately beneficialimplications for financial markets. The opposite is, of course, true shouldproductivity growth fall measurably below trend or labor compensationgrowth surge due to rapid tightening in labor markets.

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This commentary is produced by Moody's Economy.com, a division of Moody'sAnalytics Inc., which is engaged in economic research and analysis. This commentary is independent and does not reflect the opinions of Moody's Investors Service Inc., thecredit ratings agency. Both Moody's Analytics and Moody's Investors Service aresubsidiaries of the Moody's Corporation. If sourcing this article, please quote Moody'sEconomy.com.
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Profit Margins Set to Reverse This Year

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