The drag on earnings growth from higher interest rates

In my note against Cassandras who expect interest rates to rise to much higher levels, I have argued that because of the massive debt load of businesses, higher interest rates cannot be sustained for long because they reduce investment activity too much and thus lead to a rapid decline in GDP growth. But this argument can be turned around to estimate how much of past corporate profit growth is due to declining interest rates.

Michael Smolyansky from the Federal Reserve wrote a short article about the boost in corporate earnings over the last two decades from all kinds of one-off effects. Below is a key chart from his article.

Real growth indicators for nonfinancial S&P 500 firms

Source: Smolyansky (2022)

The blue line shows the real market cap (i.e. adjusted for inflation) of the nonfinancial companies in the S&P 500, while the dotted red line shows real profit growth. They are pretty much the same with differences between the two explained by changes in PE-ratios.

Then he shows the growth in real pretax income and in real operating income (EBIT). Both pretax profit ad EBIT growth was substantially lower than net profit growth. The reason why net profits grew faster than EBIT can be traced back to a range of factors, but two stand out.

• First, effective corporate tax rates have dropped over the last two decades, meaning that companies kept more net from the gross, i.e. a smaller part of pretax profits went to the tax man and a larger part stayed with shareholders.

• Second, and more importantly, interest rates dropped, which meant that businesses could increase corporate leverage while reducing their interest expenses at the same time. Hence, businesses could use more capital to invest and expand, yet did not have to pay more for all that extra capital than in times of higher interest rates.

Taken together Smolyansky estimates that about one-third of the profit growth of nonfinancial companies in the S&P 500 was a result of these two effects. That is what the difference between 3.6% EBIT Growth and 5.4% net profit growth says (1.8 / 5.4 = 1/3).

The problem is that now, the cost of debt is rising and companies have to pay more for their debt or decide to reduce debt. Either way, net profit growth will be reduced significantly. Add to that corporate tax rates that are unlikely to fall further and you can see how permanently higher interest rates would immediately destroy a lot of the earnings growth of companies. But with lower earnings growth comes a falling stock market and this, in turn, means fewer investments by businesses and less consumption by households – both of which translate to lower GDP growth.

The two ways to get earnings growth up again and justify higher valuations are by reducing interest rates to low levels or to boost productivity growth. The former is relatively straightforward to do and can be done by one central institution, the latter is highly uncertain and needs a coordinated effort by many participants in the economy. Which one do you think is more likely to happen?