Q4 Corporate Profits Sink - Thank Goodness For Wall St

By: Paul_L_Kasriel

The important new information in the Commerce Department's third guess at last year's fourthquarter GDP was its first guess at the same quarter's corporate profits. Commerce guessed low. Before-tax profits adjusted for inventory valuation and capital consumption turned negative sequentially, submerging 0.30% (not annualized) in Q4:2006. In fact, after a Q1:2006 surge of 12.60%, corporate profit growth was downright anemic in the last three quarters of 2006, as was real GDP growth (see Chart 1 below).

With volume growth slowing and labor costs rising, it is no wonder that profits growth is now struggling. It is doubtful things will turn around soon unless Circuit City's plan to effectively cut the salaries of many of its employees becomes the norm.

Chart 1

With profit growth slowing sequentially last year, why do you think the stock market performed as well as it did? Do you think it might have had something to do with the massive "retirement" of corporate equities? With profit growth slowing, how did corporations fund these massive buybacks? By stepping up their borrowing relative to their capital expenditures, of course (see Chart 2). Current equity bulls better hope that "liquidity" continues in the credit markets so that corporations can continue to retire their equities.

Chart 2

The fourth-quarter contraction in corporate profits would have been worse had it not been for Wall Street's profits and profits of U.S. corporations earned abroad. Profits of domestic nonfinancial corporations declined 6.63% in the fourth quarter while profits of domestic financial corporations and profits earned from abroad increased 4.32% and 15.90%, respectively. The creation of mortgage-related financial instruments has been a money machine for Wall Street in this expansion. Now that mortgage credit growth is in a steep decline, Wall Street will have to find another money machine. I have complete confidence it will.

The revisions to fourth-quarter real GDP were minor - a little less private fixed investment, including both residential and nonresidential, fewer imports and a little more inventory building. Domestic demand, excluding inventories, grew at an annualized rate of only 1.92% in the fourth quarter and averaged a puny 1.8% in the three quarters ended Q4:2006 (see Chart 3). The first quarter is not going to be any better, probably worse! Details of the GDP revisions are shown in the table below.

Chart 3

By Paul Kasriel
The Northern Trust Company
Economic Research Department - Daily Global Commentary

Paul joined the economic research unit of The Northern Trust Company in 1986 as Vice President and Economist, being named Senior Vice President and Director of Economic Research in 2000. His economic and interest rate forecasts are used both internally and by clients. The accuracy of the Economic Research Department's forecasts has consistently been highly-ranked in the Blue Chip survey of about 50 forecasters over the years. To that point, Paul received the prestigious 2006 Lawrence R. Klein Award for having the most accurate economic forecast among the Blue Chip survey participants for the years 2002 through 2005.

The opinions expressed herein are those of the author and do not necessarily represent the views of The Northern Trust Company. The Northern Trust Company does not warrant the accuracy or completeness of information contained herein, such information is subject to change and is not intended to influence your investment decisions.

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