Q2’s GDP Revision Offers a Check-Up on Corporate America

If ever we needed evidence that August is a slow news month, we got it Thursday when the second estimate of Q2 US GDP stole many headlines. It wasn’t just the slight upward revision to a -0.6% annualized contraction that grabbed the world’s attention, but the sharp divergence with gross domestic income (GDI), which rose 1.4% annualized—theoretically an odd development considering GDP and GDI are technically opposite sides of a ledger that should balance (but rarely ever actually do). We don’t really get the hype, though, considering GDP and GDI have different data inputs and accounting adjustments, which can have greater variability when inflation is high. More interesting to us: Corporate profits, which accelerated and, when compared to yet another measure of gross output, suggested profit margins are widening. It is backward-looking, and the Bureau of Economic Analysis’s (BEA’s) corporate profit measure includes more than publicly traded companies, but we think it shows the gap between sentiment and reality remains in stocks’ favor.

The BEA offers a few corporate profit measures, and all accelerated bigtime from Q1. The topline measure, which adds some accounting maneuvers, flipped from Q1’s -2.2% annualized decline to 6.1% growth, while the after-tax version erased Q1’s -4.9% drop with 9.1% growth.^[i] Or, if you prefer, the after-tax measure with no accounting adjustments shot from 1.0% annualized growth in Q1 to 10.4%.^[ii] Now, none of these measures are inflation-adjusted, but that is sort of the point, as inflation jacks up businesses’ costs and revenues. Given profits slowed to a crawl in Q4 and dropped in Q1, it appears businesses at first tried to swallow price pain without cranking up customers’ costs. That changed in Q2, as firm demand gave them pricing power across the board, letting them recoup Q1’s pain and then some. If you are reading this as a normal American trying to make ends meet at the supermarket, this isn’t good news—we don’t dismiss that. But for business owners? Companies large and small trying to weather the storm? Rebounding profits show resilience in the face of high inflation. If you own stocks, you own shares in this.

A quick-and-dirty calculation of profit margins provides another way to see this. Non-financial corporate businesses’ after-tax profits before accounting adjustments improved to 15.5% of their gross value added (GVA), which is basically a company’s sales revenues minus the cost of goods sold—in other words, the value it adds at its stage in the supply chain.^[iii] GVA doesn’t reflect pure profits, however, as it doesn’t back out labor and other costs. After-tax profits do, so the ratio is basically the percent of net revenues that is pure profit. Obviously, the math isn’t as clear or simple as single-company gross operating profit margins, which are revenues minus cost of goods sold divided by revenues. But as an analogue for broad Corporate America, it is an ok metric, and one analysts occasionally look to. And it is significant: That 15.5% ratio, as Bloomberg pointed out, is the highest since 1950. Let us repeat: The biggest non-financial corporate profit margins in over 70 years happened as consumer price inflation hit a 40-year high. They also happened as producer prices, which represent companies’ input costs, rose at a much faster rate than consumer prices, which represent their revenues. If there is a better sign of businesses’ ability to overcome today’s economic pressures, we are hard pressed to think of it.

Now, we won’t go so far as to call this some whopping forward-looking positive. The numbers are backward-looking, reflecting what happened from April through June, and we are now in August’s twilight. Stocks are busy looking ahead to the next 3 – 30 months or so, not at events 2 – 5 months ago. They also reflect all US businesses, most of which aren’t publicly traded, and without a detailed industry breakdown in this first estimate, it is impossible to know how much Energy firms contributed to the banner results. Probably quite a bit, considering oil and natural gas price swings. But we also aren’t sure those details totally matter, as stocks are pretty good at looking at the big picture. Simply, markets move most on the gap between reality and expectations, and headlines have warned for months that inflation would hurt small and large businesses alike. And initially, late last year and early this year, there was a pinch. But now things appear to be going far better than expected.

Perhaps, just perhaps, that is part of the reason for stocks’ rally since mid-June. Whether or not it proves to be the beginning of a new bull market, we think it is telling that it predated apparent improvement in these data and other econometrics. Stocks regularly move ahead of the broad economy, and it is quite normal for the rebound to arrive before data confirm the economy is getting better. It happened in 2020, when stocks bottomed before GDP. Ditto in 2009. If this rally holds, it would fit nicely with that history.