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Grim (equity) tidings

How much have falling interest and tax rates contributed to corporate profit growth in the US? A lot, according to a new paper out of the Federal Reserve, which our colleague Chris Flood kindly highlighted for us.

The paper, authored by Michael Smolyansky, a senior economist at the Fed, points out that before the financial crisis the ratio of interest and tax expenses to earnings before interest and taxes (EBIT) hovered around 45 per cent. Earlier this year this measure had slumped to just 26 per cent.

The main driver has been the remarkable decades-long drop in interest rates, which has compressed the cost of debt servicing to record lows, even as corporate leverage has ballooned. For our readers who have been living under a rock, the Fed is expected to raise rates 75bp this week.

Profits have also gotten a lift from a lower effective corporate tax rate, measured as total tax expenses divided by pre-tax income. It has fallen from about 30 per cent two decades ago to 16 per cent today. Combined, the two factors account for one-third of all profit growth for S&P 500 non-financial firms over the past two decades, Smolyansky estimates.

“This is a very substantial contribution,” he notes. Quite. Smolyansky reckons that even this estimate is likely optimistic.

Importantly, these calculations only take into account the direct, mechanical effect of lower interest and tax expenses on net income. To say that corporate profits would have grown at a 2 percentage point lower rate had interest and tax expenses not declined therefore ignores indirect, or general equilibrium, effects. In particular, one would expect that lower interest and tax rates would themselves have provided a stimulative boost to economic activity and to EBIT. In this sense, had interest and tax rates not declined, the real growth rate of EBIT, and net income, would most likely have been even lower than 3.6 per cent.

The implication for equities going forward is . . . not great.

“The boost to corporate profits from lower interest and tax expenses is unlikely to continue, indicating notably lower profit growth, and thus stock returns, in the future,” Smolyansky writes. You can read the whole downbeat conclusion here.

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