Good Company

July 2006

Economic cycles occur regularly, but each has its own distinctive features.

One of the outstanding characteristics of the current U.S. cycle has been the growth in corporate profitability. After five consecutive years of increase, corporate earnings have reached a record share of national income, and profit margins stand at their highest level in post-war history.

Adding to this impressive list of milestones, U.S. companies are expected to report another strong earnings performance for the second quarter of this year. This will be the th consecutive quarter that profits have grown by at least 10 percent—a three-year streak that has only happened once before.

If this run were to persist through the end of the year, as analysts predict, then it will be the longest double-digit quarterly expansion since records began in 1950.

Factors behind this remarkable performance include:

• A weaker dollar, which promotes stronger domestic pricing power, helps U.S. companies gain market share, and boosts reported earnings as results in stronger currencies are translated into more dollars back home.
   
• Reduced corporate tax rates
   
• Diminished interest expense due to lower interest rates and less debt financing
   
• Decreasing depreciation expenses due to the slow recovery in capital spending and higher operating rates, which spread such fixed costs over a broader base
   
• Revenue growth due to nominal gross domestic growth
   
• And, most important, restrained increases in unit labor costs due to excellent productivity, modest wage gains, global labor arbitrage and outsourcing

Because of this improved profitability, corporate activity will increasingly support the current economic cycle, which was until recently driven by consumer spending.

The anticipation of profit, after all, is the fundamental driver of business spending, and the current profit cycle is sending a clear signal. It is not surprising, for example, that business investment rose at the fastest pace in almost six years in the first quarter of this year.

The current environment should encourage increased spending on all business fronts including structures, equipment, inventories, employment and acquisitions, which are already running at record levels.

The stock market, meanwhile, responds to economic activity primarily through interest rates and profits. The profit cycle has driven the recovery in equity markets since the bear market lows and provides underlying support during the current market turbulence.

The environment for profit growth, however, is apt to turn less favorable going forward. Economic growth is slowing, and margins cannot expand indefinitely. Pressure from higher unit labor costs, for example, will increase.

The profit deceleration, however, will be gradual. Earnings comparisons are likely to remain positive well into 2007, if not beyond.

The profit cycle, in other words, will probably remain surprisingly strong—and will provide a solid foundation for equity performance for the longer term.

Orie L. Dudley Jr.
Chief Investment Officer
Northern Trust