Jeremy Warner's Outlook: Stock markets buoyed by record profitability

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The Independent Online

Unilever And GlaxoSmithKline rather spoilt the party, but they were the odd ones out this week as the corporate reporting season gathered pace; all over the place, companies are announcing buoyant profits. After Barclays, BP and Shell comes Royal Bank of Scotland Group, HSBC and a whole host of others all likely to report profits for last year of mind-boggling proportions. Across a broad front of sectors and industries, the numbers just keep rising. Nor is it only the profits that are gushing. Balance sheets too have rarely been healthier, allowing for fat dividends and big share buy-back programmes.

This is not a phenomenon confined to Britain. To the contrary, British profitability looks if anything a little behind the curve against what's going on elsewhere. Corporate profits are booming the world over, not just in nominal terms, but also as a share of GDP, which is approaching near record levels among the Group of Seven richest economies.

The reasons are well rehearsed, for there is always a boom in profits at this stage of the economic cycle. This is because costs, which will have been cut deeply during the downturn, tend for some years to lag the return to growth in revenues that occurs when the economy picks up again. For a while, companies are able to resist the pressure for higher wages and to take on more workers, if only because in the early stages of an upturn, nobody's too sure whether it is for real. But as the good times roll and the labour market tightens, eventually they will give in. After the boom comes the bust, and the cycle begins again.

One reason why British corporate profitability lags others is that we never had much of a downturn in the first place. Cost cutting was therefore not as marked as it was in the US, Japan, France and Germany. The consumer boom the Bank of England was able to trigger with low interest rates meant that something close to full employment was maintained throughout the downturn. The curiosity is that wage claims too have remained subdued, despite the tight labour market, but that's a different story.

So if corporate profits are booming, how come the stock market isn't booming too? Well, up to a point it is. Shares have been rising steeply for nearly two years now. The fact that despite recent gains, most stock markets remain stubbornly below their turn-of-the-century peaks is accounted for almost wholly by the meltdown that has occurred in the bubble sectors of technology, media and telecommunications. With few exceptions, shares in these sectors remain deep in the doldrums. Even Vodafone, whose networks are now generating oodles of cash, is but a pale shadow of its former self in terms of its share price.

Strip out these stocks, and things look a great deal rosier. Hundreds of column inches have been devoted this week to the FTSE 100 breaking back through the 5,000 mark for the first time in two and a half years. Less commented on is that the index of the next biggest 250 stocks, made up of a much more diverse and domestically orientated group of companies than the FTSE 100, is again trading at an all-time peak. The FTSE 100 is still 28 per cent below it.

If profits are at or close to their all-time highs as a proportion of GDP, then surely they can go only one way from here on in? And if stock markets are essentially back to former peaks once you strip out the bubble sectors, won't they go the same way as the profits? These are the $64,000 questions, to which I only wish I knew the answers. In past cycles, record levels of corporate profitability have always in the end triggered wage inflation. As costs rise beyond the growth in revenues, profitability begins to fall once more, and with lower levels of profitability comes falling share prices. The contention that this time it's different rests largely on two arguments. One is that the best of the productivity gains allowed by the IT revolution have yet to come. The second is that rapid development in China and India is creating an inexhaustible source of cheap goods, which will help to keep wage inflation permanently low. Believe it when you see it.

As for the stock market, that's an even tougher call. Yet there is perhaps some guidance to be had from the latest Global Investment Returns Yearbook, published by ABN Amro in conjunction with the London Business School. An exhaustive study of long-term rates of return in 17 national stock markets by Elroy Dimson, Paul Marsh and Mike Staunton of the London Business School finds that there is virtually no correlation between high levels of economic growth and high levels of stock market return. To the contrary, countries showing very rapid rates of economic growth tend to have the poorest performing stock markets.

This is because very high levels of growth generally end in very deep periods of recession. They also tend to attract an oversupply of capital, which means that returns fall correspondingly. And finally, in fast-growing economies the lion's share of the spoils will always be taken by the workforce, not corporate profits. It is to mature, plodding, slow-growth countries that you must turn for the best and most consistent long-term rates of return. The same is true of individual stocks. Growth companies are capable of sensational short-term share price performance, but few make it into orbit. Most will fall back to earth, like spent rockets. It is the big, boring stalwarts with established market positions that are ultimately the more reliable and consistent.

So where do London shares fit into this matrix? As with corporate profitability, Britain has also been a bit of a laggard in terms of stock market performance. Since Labour came to power in May 1997, the FTSE All Share index has underperformed most of its peers, including the main indices in the United States, Germany and France.

Right-leaning commentators have been quick to blame this phenomenon on the Labour government itself, which has abolished the tax credit on dividends, boosted public spending and increased the weight of regulation and tax on business. Yet the numbers don't entirely support the argument. Despite the abolition of the tax break on dividends, dividends have continued to rise and still make up a greater proportion of the rate of return on equities than almost anywhere else.

It is in capital growth that the British stock market has fallen behind. The reasons for this appear to be more structural than political. Big pension funds and life companies, historically the biggest buyers of UK equities, have in recent years turned into substantial sellers as liabilities mature. It may be some years yet before the buying of defined-contribution pension arrangements outweighs the selling of the final-salary schemes.

Furthermore, the economy isn't looking as buoyant as it was. The consumer boom which sustained it through the post-bubble business downturn is slowing fast. Retailers had a rotten Christmas, January wasn't much better and all the signs are that February will be worse. The release of government papers this week under the Freedom of Information Act has reminded us of the 15 per cent interest rates rose to at the height of the ERM crisis in 1992. The 4.75 per cent charged today looks insignificant by comparison, yet it's still one-third higher than it was little more than two years ago. Many householders will be feeling the pinch.

With higher taxes a virtual certainty after the election, the squeeze on consumption can only get worse. If workers try to recoup the losses through their wage claims, they'll only be punished with higher interest rates still. And if corporate profitability isn't quite as good in Britain as it is elsewhere, then there's not going to be as significant a pick-up in business investment to compensate for the slower rate of growth in domestic demand. Still, no need for panic. The message from the ABN Amro/London Business School report is that the slow plodders win through in the end. Britain's success in ironing out the peaks and troughs of the cycle seems to put us in the vanguard of the plodders.