UK: Profitability Monitor – 2007 Q2

• The rocketing rate of profitability, up from 15.1% in Q1 to 15.7% in Q2, will help to offset some of the downward pressure on business investment from any tightening of credit conditions. But I expect profits growth to start weakening at the start of next year as economic growth slows.
• The further rise in annual profits¹ growth in Q2 to some 20% is thanks in part to the fact that the economy has recently been running at full steam. GDP has been rising at a robust annual rate of over 3.0%, with the Monetary Policy Committee suspecting that even this is an underestimate of the true rate of growth. And surveys suggest that this momentum has continued into the third quarter.
• The strength of demand is still giving at least some parts of the economy the confidence to raise their prices further. Manufacturers’ price expectations, in particular, remain at unusually high levels.
• The more recent news on energy costs has been less positive with the oil price having rebounded to close to $80 per barrel. Nonetheless, the sheer momentum in profits growth suggests that profits are now likely to rise by around 10% this year, rather than the 6% that was looking likely before. This would match the increase seen in 2004, when the economy was last roaring away.
• Things will get tougher next year, however, when I expect GDP growth to slow from the 3% seen this year to a rather more sluggish 2%. Given that profits are highly cyclical, I expect profits to post a modest nominal rise of about 1% at best.
• Although official interest rates have probably peaked, the previous rate rises are yet to have their full effect on demand. Rates first rose last August, but in the past, it has taken 12 to 18 months for consumer spending growth to weaken markedly. Even if the MPC soon starts to lower rates, the cuts will take time to take effect.
• In addition, the credit crunch is likely to have the same effect as a further monetary tightening. A general re-pricing of risk could prompt both corporate and household borrowing rates to rise and credit to become less widely available.
• The housing market is already weakening, so this increases the chances of outright house price falls, with obvious implications for consumer spending.
• The slowdown in economic growth should have a clear effect on firms’ pricing power. In fact, in the past couple of months, retailers already appear to have shifted their focus back to cutting prices more aggressively to keep shoppers interested.
• Those firms who primarily sell to abroad will not emerge unscathed. I already expected the US economy to slow, but following the recent subprime crisis, the downturn now looks set to be more severe – I expect US growth to slow from 2.5% to 1.7% next year. (See Chart.) The euro-zone is a more important export destination for the UK. But there are signs that growth is starting to slow there too.
• Admittedly, the recent high levels of sterling have not prevented a strong recovery in manufacturing output growth. But manufacturers appear to have sacrificed margins to achieve strong sales. Profitability in the manufacturing sector was just 8.4% in Q2, compared to 21.4% in the services sector – yet back in the mid 1990s, the two were almost equal.
• Meanwhile, it looks unlikely that firms can keep pay growth quite so squeezed as of late. Labour costs could start rising just as revenues come under pressure.
• The UK is still a long way from recession. But even a modest slowdown in GDP growth will prompt a much sharper slowdown in profits growth. Corporates should enjoy the goods times while they can.

Footnotes

1. Nominal gross trading profits of non-oil non-financial companies.

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