Profits plunge points to dark times ahead

News analysis: Has the UK economy really managed to achieve a soft landing?
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The Independent Online
ALMOST EVERYONE whose job it is to monitor the economy, including the Bank of England, believes the UK has achieved a soft landing and is now set for slow but stable growth.

GDP growth is not falling, record numbers are in work, consumer confidence is buoyant, there is talk of another housing boom and even manufacturers, a justifiably cautious bunch, are less gloomy.

And yet, just when optimism seems the flavour of the season, along comes a piece of data that appears to run counter to this rosy picture.

In the first quarter of the year, corporate profits fell by 9.4 per cent - the sharpest rate for 25 years, in fact since Britain was in the grip of the three-day week in 1974.

The figures - officially known as gross corporate operating surplus - were included in data from the Office of National Statistics that last week showed zero GDP in the first quarter.

Yet over the same period the stock market, as measured by the index of the 100 biggest companies, rose by about 7.5 per cent.

Does the economy have a problem? Does the stock market have a problem? On one level the answer is "yes" to both questions.

The fall in corporate profits was bound to be seized on at a time when markets on both sides of the Atlantic have achieved all-time highs.

The Dow Jones has surged from 7,400 in October to 11,100 at its peak in May - traditionally the month for the start of the big summer sell- off. The Dow has already lost 600 points since its peak; analysts believe that a major correction is around the corner and are waiting for signs of a major economic setback.

As share valuations must be supported by profits, a profits fall could be seen as adding weight to claims that the market is overvalued.

Robin Griffiths, a New York-based analyst at HSBC, says that such a fall is one reason why the London market would follow Wall Street in the corrective phase it has just started. "The costs of preparing for the euro and the Y2K computer problems mount up. Exports are falling and imports are rising, giving the worst drag since records began," he says. "Whatever the profits figures that analysts had been going for, they are likely to be revised downwards during the next few months."

The figures do not appear to augur well for the economy. As 90 per cent of business investment comes from retained profits, a fall in company surpluses would feed through to a decrease in investment, in turn feeding through to higher unemployment and a slowdown in GDP. Business investment fell 2 per cent in the first quarter from the last three months of 1998 to pounds 26.44bn.

The economy ground to a halt in the first three months of the year - at least after the ONS revised the wafer-thin 0.1 per cent growth down to zero.

Businesses are finding it very hard to pass rising commodities prices on to consumers in the form of higher factory-gate prices.

The latest figures show annual output prices falling by 0.6 per cent compared with a 1.3 per cent rise in raw materials. To this can be added average earnings rising at 4.8 per cent.

Meanwhile, the strength of sterling is making life hard for exporters, especially to Europe.

The GDP figures also showed net trade deficit cut GDP by 0.5 per cent in the quarter as exports recorded their second sharp quarterly drop and imports rose. This was the deepest "trade drag" since records began in 1955.

An uncompetitive exchange rate and weak European demand is eating into the profit margins of exporters, which are already finding price rises impossible in the domestic market.

Only the labour market, with its marvellous record of falling claimant count, record employment and an influx of people joining the jobs market, offers any relief.

However, there is a danger in getting over-excited about any one piece of data - however sensational the headline figure.

The previous quarter recorded a 1.2 per cent fall, but few paid much attention as it did not have the symbolism of a 25-year low.

There are also a number of caveats when using the corporate surplus figure to analyse stock market movements and the likely direction of the economy. It includes surplus contributions from public corporations, financial corporations and oil companies.

Only when the detailed figures are published in June will economists be able to subtract the figures for public corporations, financials and oils, to get a clearer picture for "mainstream corporate UK plc", says Kevin Gardiner of Morgan Stanley.

"Earnings in the stock market have been soft but not quite as soft as these data might appear to indicate," he says.

About half of the profits of the top 100 companies come from overseas earnings, which again confuses the picture.

But if the contribution of profits towards GDP is falling, then consumption must be growing. Consumption as a share of GDP is now at a record of almost 64 per cent.

As more than 40 per cent of consumer spending is on services, this could create an inflation risk, according to Geoffrey Dicks, of Greenwich NatWest.

The service sector is more labour intensive and less productive than manufacturing, while prices in the services sector are rising faster, he says.

"If low levels of unemployment create further wage pressure in the service sector, high service-sector inflation will make it more difficult to hit the 2.5 per cent inflation target."

Manufacturing and export industries may be weak but so far the corresponding strength in the service industries, the housing sector and the labour market has created inflation worries for the Bank of England and so blocked any more rate cuts.

Even if the latest GDP figures are revised down to show that the UK endured a technical recession - defined as two consecutive quarters of negative growth - over the winter, it looks as if the economy has managed a soft landing.

There may even be enough positive indications that we are ready for what the Bank called a "gentle take-off" at the time that it published its May Inflation Report.

The issue as we go forward is whether, given the imbalance in the economy, the Bank's Monetary Policy Committee can cope with a revival in the manufacturing sector if sterling finally starts to come off its current highs.