Profits and Financing in the Nonfinancial Sector

In the ninth year of the current economic expansion, the manufacturing sector continues to chug along, but should we be wary of any signals in this stage of the business cycle?

Manufacturing Sector Demonstrates Durability

As we reported last week, corporate profits as a percentage of nominal GDP appear to have peaked in this cycle, which suggests caution to the economic outlook. The revised Q3 GDP report also suggested that foreign corporate profits were the major driving force behind the increased print for the third quarter. These two statements taken together do not inspire much optimism for strong domestic profit growth going forward. The manufacturing sector, however, appears to be positioned for continued solid corporate profit growth, albeit at a gentle pace.

Slow and Steady

The U.S. Census Bureau released its Quarterly Financial Report for the third quarter, detailing profit growth in the U.S. manufacturing, mining and wholesale trade industries. U.S. manufacturing corporations’ seasonally adjusted after-tax profits in the third quarter totaled $147.4 billion, up $3.7 billion from the second quarter. Durable goods manufacturers’ after-tax profits were up $4.5 billion quarter over quarter and up $6.8 billion year over year. Manufacturing after-tax profits have increased for four consecutive quarters, suggesting growth momentum remains intact. Moreover, the ISM manufacturing index’s six-month average of 58.4 continues to signal firmness in the sector. The survey also revealed that 11 of 18 industries reported employment growth, a likely boon for the employment numbers to be reported this Friday. In sum, within the corporate profit space, the manufacturing sector appears to be a bright spot.

Financial Analysis Suggests Attentiveness

The interest coverage ratio (operating income/interest expense) of firms serves as a useful barometer of financial health. In the manufacturing industry, the interest coverage ratio has been on a downward trend since early 2015, indicating that these firms have less of a cushion when paying back interest on outstanding debt (middle chart). It should be noted, however, that despite the downward trend, the ratio currently stands at 3.72, which is in line with the series’ historical average. Meanwhile, capital expenditures have continued to trudge higher, which has caused the financing gap to turn positive recently (bottom chart). The continued rise in capital expenditures has some positive implications, as it may provide a lift to the historically weak pace of productivity growth we have seen in this cycle. Moreover, it also implies that these companies have enough confidence in future sales prospects to justify ramping up new investments in their business.  Investors and corporations will certainly be paying close attention to the FOMC meeting next week. If Fed officials increase their growth and inflation forecasts, this would imply stronger nominal sales growth, which could translate into healthy corporate profit growth.

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