US celebrates as profits soar

Wall Street is celebrating the highest corporate profit margins in decades. But as profit growth looks set to peak, is the party nearly over?

Get the champagne out, Wall Street. US corporate profit margins are at their highest in many decades and the latest earnings season is shaping up to be another excellent one. Of the companies who have already reported, two-thirds have beaten estimates. "The winning streak is showing no signs of ending yet," says Jennifer Hughes in the FT. "There is little expectation that corporate America is about to fall off any cliff."

But not everyone is so upbeat. "A recession over the next two or three years is likely, and a marked decline in profit margins is virtually certain," says Andrew Smithers, quoted on And when economic growth and profit margins come down, it may be with a thud, as central banks battle inflation with higher rates. In the process, equity values may halve, says Smithers, who has a good track record in this respect: he correctly predicted double-digit downturns on Wall Street in 2000 and in Japan in 1990.

Other analysts are coming around to the view that profit growth is about to peak. "The extraordinary era of high profitability and profit growth is drawing to a close," says Andrew Cates of UBS, also on The fundamentals supporting high profits above-trend global growth, productivity gains, slack labour markets, low real interest rates, and weak capital goods prices are beginning to fade. UBS's models suggest a gentle slowdown in corporate profit growth in the G7 countries, but Cates agrees that sharply higher rates could mean a much more drastic fall in margins.

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Faltering profits would be bad news for markets, says Edward Chancellor on People continue to claim that valuations are cheap, but that argument is suspect. American stocks have historically traded on an average of 14 times historic earnings, but the S&P 500 currently sells for around 14 times its forecast profits, meaning that this season's good news is already priced in. If current profit margins revert to trend, the market will look very pricey. On top of that, shares are being boosted by huge buybacks by firms of their own shares. If profits slip, buybacks will stop and that crutch will be kicked away. The party is likely to end in a huge hangover.

When investments constantly hit the headlines, it's often a sign that a bubble is about to burst. So the fact that private equity is all over the front pages suggests that the only way from here is down.

Enormous amounts of money are sloshing around the industry. Private equity buyouts account for one in three of all business purchases, and, sales-wise, they account for many more, says Heather Connon in The Observer. The top five investment houses have a £38bn war chest that has to be spent by 2010 and sums like that mean almost any target even the likes of Vodafone, BT, Unilever and M&S could be in play. But the mergers and acquisitions market is looking increasingly unstable, says Bryce Elder in The Times: "Chief executives are making decisions based not on financial logic but on unshakeable opinion of their own brilliance". The deals they cut are increasingly debt-laden: the average one involves six times as much debt as earnings, up from 5.5 in 2005, Fitch Ratings reports. That's fine while debt's cheap, but as Permira's Charles Sherwood tells Connon, if interest rates rise, then assets will have to be re-priced, which may scare investors away from new deals.

And higher rates could also clobber share-holders in debt-loaded firms that have been refloated by private equity buyers. Debenhams was taken private in 2003 by CVC, Texas Pacific and Merrill Lynch in a £1.8bn deal, of which £130m was reportedly debt. It was refloated in May with a £2.8bn valuation, more than 50% of which was debt. The firm, says Elder, is now "not much more than a gamble that consumers will keep spending".

by Alex Ferguson