If the prolonged period of declining and ultra-low interest rates is over, what does that mean future corporate profits, cash flows and dividends? Head of Franklin Templeton Institute, Stephen Dover, opines.
Let’s step back from the daily market gyrations to consider secular trends impacting longer-term asset returns and strategic asset allocation decisions. If we assume that a prolonged period of declining and ultra-low interest rates is over, then the rate at which future corporate profits, cash flows and dividends are discounted will be higher. Higher discount rates imply lower equity valuations (lower price-to-earnings ratios). If profitability is also peaking, then the inescapable conclusion is that stock market returns will likely be lower in the years to come than we’ve come to expect in our lifetimes. Are we doomed to this fate or are there factors that could turn the tide?
What the data show
We begin with a review of the data—specifically the US national income accounts1—which capture economy-wide measures of profitability. National income estimates of profits include listed and unlisted firms, small businesses and sole proprietorships, and hence provide useful insights into broad drivers of overall business performance.
As Exhibit 1 demonstrates, the share of pre- and after-tax corporate profits in the United States has been on an upward trend over the past three decades. To be sure, periods of deep recession (e.g., 2008 and 2020) sharply interrupted that rising trend, but the unmistakable tendency since 1990 has been for corporate profits to garner an ever-larger share of the economy.
According to the most recent figures (second quarter 2022), US after-tax corporate profitability reached its highest share of gross domestic product (GDP) in nearly 70 years. Pre-tax profits as a share of GDP were also near their postwar record highs. It is also interesting to note that corporate profits after tax have grown more than pre-tax income as corporate tax rates have fallen.
Macroeconomic and listed-company definitions of profits can differ—for example when accounting changes are significant or financial stress is acute. But, in general, national income-based profit measures and those for listed companies move broadly together. For example, S&P 500 corporate profit margins have been on a multi-decade upswing that saw average margins rise from 6% in the early 1990s to a postwar record of 15% on the eve of the pandemic.2 That bears a strong resemblance to the rise in profits as a share of GDP depicted in Exhibit 1.