The earnings squeeze

Companies are being hit by a profits crunch with margins at an all-time high as growth slows and costs rise. Sean O'Grady looks at what is causing the pain
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The Independent Online

After the credit crunch – the profits crunch.

This time last year, the world's capitalists could relax over a glass of champagne and reflect that the profitability of the world economy was running at multi-decade highs. No one predicted the collapse of Northern Rock, let alone the failure of the United States' fourth largest bank, Bear Stearns. The approximately $120bn (£60bn) written off by the world's financial institutions on mortgage-backed securities has already dented the profitability, and reputation, of the financial world.

As a significant proportion of the increase in the profitability of global commerce was built on the back of the cleverness (supposed or real) of financiers in the City and Wall Street, their precipitate decline into losses will depress the corporate earnings numbers for some years to come. Rescue rights issues and the sovereign wealth funds' stakes can't change that.

Beyond the obviously distressed financial and real estate sectors, things do not look so grim, but there are indications that profitability is becoming the subject of a classic "squeeze". Profits, after all, are no more than the difference between costs and revenues, and on both counts the outlook is poor. Input costs are higher because of record commodity prices; in the UK and the US a weak currency has pushed them still higher.

Meanwhile the credit crunch is increasing the cost of servicing debt, and profits, which are usually easier to adjust, suffer more in a downturn than wages, which tend to be "sticky" as workers' resist pay cuts. But the downturn means firms are finding it increasingly difficult to pass on higher costs, with fewer consumers spending less as they watch the value of their homes decline and their banks call in their credit cards. Hence the squeeze.

Yesterday's data from the CBI proved the point. British manufacturers report the fiercest increases since 1990 in unit costs. Yet even if consumer prices rise by more than the 3 per cent widely expected later this year that will represent a remarkable degree of restraint given the double-digit increase in energy and raw materials costs. Part of the key to that is relatively slow growth in real wages, these accounting for around 70 per cent of the costs of British business. And Ian McCafferty, CBI Chief Economic Adviser, warned: "Manufacturers are being forced to pass on higher costs to customers by increasing prices, and are no longer able to absorb continuous cost increases into their profit margins."

So earnings are being squeezed. In America, the last quarter of 2007 saw corporate profits crash by 3.3 per cent and in Europe profit growth declined to 0.8 per cent on the quarter. The latest research from Morgan Stanley suggests that "the biggest certainty for the next 12 months is that there will be a big earnings miss, as margins are at all-time-high levels while topline growth is slowing and costs are rising, and expectations are too high".

They say the pain is spreading beyond banks, to large industrial and technology groups such as GE and Nokia, with disappointing first quarter results from the likes of TomTom, Philips, Accor hotels and Cadbury. On a pan-European basis, winning sectors are expected to include capital goods and raw materials – benefiting from continuing Chinese demand.

Much does depend on the ability to pass on cost increases. Thus, for example, non-food retailers hit by rising energy and transport costs are less able than food retailers to simply mark up prices because consumers have to buy food but can choose whether to buy DVDs, iPods and cars. Tesco may do better than Currys. The transport sector is also suffering badly, as the British Airways share price shows.

Perhaps the most telling indicator is how far profits have strayed from historic norms – and thus how far they have to fall to get back on track. America's after-tax profits rose to their highest as a proportion of GDP since 1929, an uncomfortable precedent. The shares of profit in the euro area and Japan are also close to their highest for at least 25 years.

In terms of average earnings per share, a measure of market optimism as much as hard profitability, US companies have been running at extreme levels, way higher than the long-term trend of growth and higher than in any previous stock market bubble.

Until the credit crisis, capitalists had never had it so good. Globalisation, the collapse of union power and the entrance of China, India and the ex-Soviet bloc to the world economy pushed wages lower and helped profits higher. Then new technologies, higher productivity, and generally more business-friendly governments also helped.

The fundamental trends will resume after this cyclical drop, although perhaps more slowly if oil at $120 a barrel becomes the norm. Profits will rise again, and sharply in areas such as finance, but the wait may be longer than many anticipated. Don't put the champagne on ice just yet.