Corporate Profits Set to Slow After Stellar 2018

November 27, 2019
By Patrick V. Masso, CFA

As the Tax Cuts and Jobs Act was signed into law in December 2017, corporations saw their tax rate drop from 35% to 21% with the stroke of a pen. This tax rate decline contributed to profits blasting higher in 2018.

Profitable companies have several options for use of their cash piles each year. They can reinvest in the business, pay down debt, or return capital to shareholders in the form of a dividend or stock repurchase (buyback).

Some of the tax savings were, indeed, used to increase business spending on things like equipment and buildings to support company operations and future growth opportunities. A handful of companies also chose to invest in their workforce.

Then there were the 2018 stock repurchases to the tune of $1.1 trillion – a record annual pace.

When a company buys its own stock, it reduces the number of shares outstanding. This is not a new strategy. In fact, corporations have been a significant buyer underpinning equity market prices since the end of the Great Recession.

Stock buybacks impact the earnings per share numbers reported by a company each quarter. For instance, let’s suppose company XYZ earned $1 million in 2017, with 1 million shares of stock outstanding at the end of the year. This equates to an earnings per share figure of $1.00/share.

Let’s further suppose, in 2018, the company earned another $1 million, but instead of ending the year with 1 million shares of outstanding stock, the year ended with only 950,000 shares, because the company had bought 50,000 shares of their own stock with some of the cash hoard. This equates to an earnings per share figure of about $1.05/share.

Poof! A 5% increase in earnings per share, despite actual dollar earnings remaining flat at $1 million.

Layer on top of this trick a substantially lower tax rate and you can see why 2018 was such a powerful year for corporate profit growth. The chart on the first page shows US corporate profits thrusting higher and reflects the positive influence of the cocktail of lower taxes and significant redeployment of cash into buying back company stock.

In 2019, corporate America is now faced with lapping the impact of the Tax Cuts and Jobs Act. Last year’s excellent profit figures set an exceedingly challenging benchmark for 2019 comparisons.

In fact, the year-over-year growth rate in corporate profits was actually slightly negative for the S&P 500 in Q1 ’19. Consensus estimates for Q2 ’19 earnings per share growth is about -2.5%. This compares to more than 20% year-over-year earnings per share growth experienced in 2018.

The decelerating growth rate in corporate profits can often bring about heightened volatility in financial markets and worries about the overall health of the economy.

Look no further than this month’s Federal Reserve meeting for evidence: on June 19th , Fed Chair Jerome Powell walked a fine line when speaking about the future path of interest rates. Over the last few years, the Fed has been steadily ratcheting up short-term interest rates. Now, there is significant speculation that a cut in interest rates is quickly approaching.

As of this writing, market participants are pricing in a 100% probability of a decrease in the Fed Funds rate in July 2019 and an increased likelihood of further interest rate declines in 2019.

Corporate profits grew gangbusters in 2018. The change in tax law and corporate buybacks fueled this growth. However, the tax booster is fading, and companies will face difficult comparisons going forward. Slowing corporate profit growth could trigger the Fed to take accommodative action soon.

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