Global share markets moved sharply higher overnight as investors shrugged off fears about the slowing global economy and the European sovereign debt crisis and piled into shares.

Indeed, many analysts argue that the sell-off in US equities is now overdone. They argue that US companies have been so spectacularly successful in shaving costs that US corporate profits have now hit the highest share of GDP in history. Even in the first half of this year, when US economic growth was a sluggish 0.7%, US corporate profits surged by almost 18%. As a result, S&P 500 companies (excluding financial firms) are sitting on $1.1 trillion in cash, or roughly 12% of their market capitalisation, which could be used for share buybacks.

The bulls argue that if the US economy stabilises in coming months, and fears about a new US recession subside, the S&P could be in for a robust rally in the final few months of the year.

But others warn that US corporate profit margins are about to be crunched. John Hussman, from Hussman Funds, points to two “unsustainable dynamics” that have boosted corporate profit margins in recent years.

The first is that the increase in profits as a share of GDP has basically come at the expense of workers. “The spike in corporate profit margins has moved hand-in-hand with the collapse in labour income. As companies cut employment dramatically in recent years, they were able to maintain relatively high levels of output, which was reflected in high productivity growth figures.”

But we have now reached the point where “there is little latitude to expand profit margins through further payroll cuts, and labour tensions are increasing as well”. He points out that the declining productivity in recent quarters, and the corresponding rise in unit labour costs “reflects the difficulty in picking much more from the bones of workers”.

The second “unsustainable dynamic” is the extent to which US government transfer payments — largely unemployment benefits — are supplementing wage income. “In fact, 22 cents of every dollar of US personal consumption is now financed with transfer payments,” he says. Hussman argues that these transfer payments are bolstering consumer demand, even though wage income is close to a record low as a share of GDP.

Of course, Hussman points out, if the US goes into recession, the US government will have to spend more on unemployment benefits, which will provide some buffer for demand. But, he cautions investors to be careful of assuming that US corporates will continue to enjoy record profit margins.

According to Societe Generale’s global strategist, Albert Edwards, US profit margins are already coming under pressure because labour costs are now increasing, while corporates are finding it difficult to hike prices because demand is weak.

Edwards says that in 2010, US corporates enjoyed hefty profit margins, as a 4.1% growth in productivity translated into a 2% drop in unit labour costs. But this year, productivity has taken a “remarkable turn for the worse”. He notes that productivity in the first three months of the year declined by 0.6% on an annualised basis, resulting in a “staggering surge” of 4.8% in unit labour costs. In the second quarter, unit labour costs climbed by a further 3.3%. At present, US unit labour costs are rising at a rate of 2%, measured on a year-on-year basis.

“That is very bad news for profits. Bad news for equities,” Edwards says. What’s more, because unit labour costs are a key driver of inflation, “it is bad news for an increasingly criticised and divided Fed”.

*This article first appeared on Business Spectator

Peter Fray

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