The Big Idea

A healthy corporate report card

Stephen Stanley | June 7, 2024

This document is intended for institutional investors and is not subject to all of the independence and disclosure standards applicable to debt research reports prepared for retail investors. This material does not constitute research.

Corporate profits surged as soon as the economy began to reopen after Covid lockdowns in 2020 and have remained robust. The latest data show a modest decline in corporate profits in the first quarter this year, but the overall picture is still quite healthy. The national income accounts also reveal that profit margins are largely steady but still elevated compared to pre-pandemic readings. That’s a challenge for the Fed.

Corporate profits

As part of the National Income and Product Accounts (NIPA), the Bureau of Economic Analysis (BEA) calculates corporate profits. Ultimately, the main source for these figures are data forwarded from the IRS compiled from corporate income tax returns. However, those data are only available with a lag, so the BEA has to extrapolate from the latest available tax data to create quarterly estimates for the most recent periods. Those quarterly estimates are derived from Census Bureau figures collected from various industries as well as the tabulations from a sample of corporate earnings reports. The BEA’s corporate profits series consequently should be broadly in line over time with the quarterly shareholder reports that financial markets focus on, but the two do not necessarily have to be entirely consistent.

Recent trends

The BEA’s gauge of corporate profits jumped in 2021 and the first half of 2022 and has roughly leveled off since then (Exhibit 1). The latest reading, for the first quarter of this year, was more than 37% higher than the 2019 level, close to double the increase seen in prices over that interval.

Exhibit 1: Corporate profits have moved higher

Source: BEA.

However, as I laid out in a piece last year, the BEA’s official corporate profits series is somewhat distorted because it includes the operating profits and losses of the Federal Reserve. The Fed went from earning record “profits” in 2021 and early 2022 to massive “losses” since late 2022, as it is paying out more in interest on reserves and RRP than it earns from its securities portfolio.

Since the Fed’s operating income is mostly an accounting issue—any “profits” are simply remitted to Treasury while “losses” are handled by writing an IOU to Treasury and printing money to cover its payouts—a proper reckoning for Corporate America requires stripping the Fed’s numbers out of the aggregate profit figures.

After excluding the Fed from corporate profits, the runup in 2021 and 2022 is less steep, but “ex-Fed” profits have continued to climb (Exhibit 2). By the first quarter of this year, this aggregate was 46% higher than the 2019 average, almost triple the cumulative increase in prices over that period. For all of the talk of higher interest rates potentially impeding business activity, Corporate America has continued to thrive.

Exhibit 2: Corporate profits, excluding the Federal Reserve, keep climbing

Source: BEA.

Profit margin

The BEA also publishes data on how real gross value added for nonfinancial domestic corporations is allocated between costs, taxes, and profits. This allows a look into profit margins, or after-tax profits as a percentage of the price charged per unit of gross value added for this subset of businesses (Exhibit 3). Limiting the data to nonfinancial firms conveniently avoids the measurement issues related to the Federal Reserve.

Exhibit 3: Nonfinancial domestic corporations profit margin is up

Source: BEA, Santander US Capital Markets

The numbers clearly show that profit margins widened after the pandemic, inching up from a 10% to 12% range to 12% to 14%. The first quarter reading did fall from 13.8% to 12.9%, which could signal the beginning of a pullback, but until the gauge falls back below 12%, it would be premature to conclude that Corporate America is losing steam.

Monetary policy implications

These profit margin data suggest that the economy remains solid, at least for now. More importantly, they tell us something about pricing power. When viewed from a distance, the expansion of profit margins after the pandemic, at a time when both labor and nonlabor costs were surging, is extraordinary. This speaks to a significant shift in pricing power that has fed the inflationary impulse that has plagued the Fed since 2021.

There have been anecdotal reports this year that consumers are starting to get their mojo back and are beginning to become more resistant to price hikes. However, the inflation genie was let out of the bottle in recent years, and whatever increase in resistance to higher prices consumers are exhibiting is nowhere near the norm in the 2010s, when businesses were constantly complaining that they had essentially no pricing power at all. I suspect that getting inflation back to 2% on a sustainable basis will require squeezing profit margins back down to something closer to the pre-pandemic trend.

Stephen Stanley
stephen.stanley@santander.us
1 (203) 428-2556

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