Of populism and profits

IF YOU look at the headlines, geopolitical risk is at record highs, with populism and strife in Europe, a coup attempt in Turkey, a tense election in America, the threat of terrorism, and tensions in the South China Sea. Peer at a stock-price screen, however, and everything seems fine. This month the S&P 500 index of big American firms roared to a new high. Benjamin Graham, a famous investor, described America’s stockmarket as a manic depressive. But now it appears to be one of the planet’s last, incorrigible optimists.

Investors are convinced that the outlook for corporate profits has improved. For the past four quarters, earnings-per-share for the S&P 500 have been falling by about 12% compared with the prior year (see chart). That has reflected the strong dollar, which crimps the value of foreign income, together with a slump at energy and commodity firms. Coca-Cola’s global sales have risen in local-currency terms but declined in dollars; ExxonMobil’s profits have fallen by four-fifths compared with two years ago.

Yet now markets believe these problems are going away. The dollar and the oil price have stabilised and the domestic economy seems to be in a Goldilocks situation for profits—not too hot, not too cold. It is growing just strongly enough to keep demand for products moving along. But wages, or labour costs, so far this year have been rising at an annual rate of only 2-3%. So America Inc can be slothful but highly profitable. In addition, firms are using high earnings to pay for share buy-backs, which have been running at $165 billion a quarter, and which help to prop up share prices.

A majority of analysts still expect profits to dip for the second quarter but then to rise, and strongly by the end of this year. Just how sensible is this expectation? One objection is that a tightening labour market may mean that wage pressures rise at last. Just a 5% rise in wages would, all else being equal, lower profits by about 15%. Yet this is not what the Federal Reserve expects, nor the bond market, which is pricing in a long period of low inflation and interest rates.

A still bigger risk, but one that is harder to quantify, is the longer-term effect of a fraught political climate upon corporate profits. Firms have earnings and cashflow at unusually elevated levels relative to GDP, while the share of output going to workers is depressed. Both sides of the presidential campaign have hit out at big firms, which many people feel are benefiting from an economy tilted in their favour.

How might such sentiment translate into lower profits? Hillary Clinton has promised to put pressure on drugs pricing (14% of all profits in America are earned by health-care firms). Her party has also promised a tougher approach on competition policy, which could hurt technology firms with large market shares. Donald Trump might pursue a protectionist agenda that would be painful for big firms that operate abroad or that rely on imported inputs (about two-fifths of S&P 500 sales are made abroad). Both parties could seek to crack down on generous tax breaks for offshore profits.

Yet investors are shrugging off such concerns, perhaps reckoning campaign promises will be quietly forgotten. For example, analysts expect pharmaceutical firms’ earnings-per-share almost to double by 2018. It may be wishful thinking. The banking sector was the first industry in America to be hit hard by a populist backlash, and it is unlikely to be the last. Its earnings were hammered—banks’ return on equity has halved over the past decade. It is no coincidence that the chief executive now doing most to head off popular discontent hails from banking. Last week Jamie Dimon of JPMorgan Chase announced that 18,000 of its rank-and-file staff would see their pay rise from $10 an hour to $12-17. He may not be the last to make such gestures.