April 10, 2002

Anyone looking at the profits estimates that were released with the fourth quarter GDP estimates would have no qualms about calling the last year a recession.  In recent years, only in the severe recession of 1982 did profits fall by a larger amount than the 15.9 percent reduction in after tax profits that occurred last year. 

The measure I use, after tax operating profits, fell a still strong 8.9 percent for the year. 

Financial institutions were the only sector to show any meaningful gains in profits.  Falling short term interest rates lowered the cost of funds relative to what banks were charging for services.  Bad loans rose in the weakened economy, but not enough to offset the benefits from a widening spread between what banks paid and charged for the use of money. 

Manufacturers of durable goods and transportation showed the largest profit declines.  The auto industry, which actually increased vehicles sold from the year before, did so at a loss.  Losses in airlines nearly offset profits at the railroads and trucking companies. 

Profit declines were strong in communications and also were noticeable for "other" services, which include temporary help agencies. 

Why did profits fall so sharply during such a mild recession?

Some costs are relatively fixed.  While businesses can reduce the number of employees, they have a harder time changing contracted labor costs per worker.  Also, financing charges for unutilized equipment still must be paid even though the equipment is creating no revenue. 

This fixed nature of costs almost always lowers profits during recessions.  That is one of the reasons why stock prices fall ahead of recessions.  Investors know that a recession will lower the earnings their investments can achieve, at least in the short run. 

Profits were impacted by the obvious destruction of existing property by the terrorist attacks and the subsequent security adjustments that made some capital unusable (e.g. the initial five hundred feet of parking at airports).  While this explains some of the reason for the poor profits in a modest recession, it certainly leaves a lot more explaining to be done elsewhere. 

Indeed, financial charges plunged for many companies as the Federal Reserve slashed interest rates.  However, sharp changes in creditworthiness may have imparted higher financing costs on some companies.  Certainly, the reduced ability to use some financial instruments, such as commercial paper meant higher finance costs than the plunging interest rates suggested. 

Yet, changes in credit quality cannot be used to explain the sharp and widespread weakness in profits. 

Generally, we are left with two related factors to explain the plunge in profits. 

First, the drop in utilization of capital was dramatic.  Not surprisingly, capacity utilization fell more rapidly than in any recent recession and reached lows that approached those in 1982. 

Second, the pricing ability for most manufacturers, many transporters, and a great many service activities virtually vanished.  

Part of this loss of price control was related to the sharp drop in capacity utilization.  Producers would prefer to cover the fixed costs of their equipment than have no revenue coming from idle plants.  As a result,  price increases collapsed under discounting by competitors. 

Some of the lost pricing ability was caused by the surprising strength in the dollar.  As the world became more uneasy, international savers flocked to the U.S.  This raised demand for our currency before these investors could buy our assets.  Our international competitors then could earn more euros, pounds, or yen by holding their prices.

Of course, their costs are in their own currencies.  Thus, our strong currency allowed some reduction in dollar prices charged by international competitors without impairing their profits in yen, pounds, etc. 

However, some reduced pricing power was deliberate.  For example, General Motors wanted to build market share.  They knew that the more profitable replacement parts will follow behind the sales of new GM products.  Thus, they sold new cars at a loss to increase future parts and service sales. 

I believe profits will snap back sharply as the recovery progresses. But the reasons for that must await.



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