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Monday October 9, 2006 - 11:37:09 GMT
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Economics Weekly

Economics Weekly: UK company profitability hits a record level - what are some of the reasons and consequences?

Figures for UK corporate profitability in the second quarter of 2006 showed that it has reached a record rate. There has been a sharp rise in company profitability in all of the major economies. But the UK report also showed that there was a sharp divergence in performance between different types of companies. We look at the data and ask what it means for default rates, bond spreads (relative to government bonds or, in the jargon, risk free assets), and hence the implications for credit ratings and other measures of company default risk.

Service companies are seeing the strongest gain in profitability in the UK, as manufacturing suffers from a low global export share
The net rate of return on capital employed by UK companies rose to 14.7% in Q2 2006, up from 14.4% in Q1. The details of the data show that services companies accounted for the bulk of the rise in the overall rate of net return, with an increase from 19.5% in Q1 to 20.1% in Q2, see chart a. But the rate of return for manufacturing firms fell to 6.1% from 6.8% in Q1 and 10.7% in the year before, as weak domestic demand hit them badly and they failed to benefit from fast growth in the emerging market economies. North Sea oil companies rate of return remains in the 30s, due to high oil prices, with only a modest fall back in recent quarters. But manufacturing growth is now recovering, boosted by a pick up in the key EU markets, and so should profitability in the quarters ahead. Services companies’ output growth has remained strong in the last few years and that explains good profitability in the context of low domestic interest rates and increased output from legal and accountancy based firms.

Is globalisation a factor driving profits share higher?
One of the consequences of globalisation is that there is greater capital and labour mobility across national frontiers, as evidenced by increasing weightings of exports and imports in national income, increased foreign ownership of domestic companies in stock markets and greater foreign direct investment as a share of total investment. The clear implication of this is that pay growth should slow and profit growth is either maintained or accelerates. The reason is that a greater supply of labour should bear down on wage inflation in any relatively free market whereas companies should have a greater ability to control other costs through outsourcing, efficiency gains and from slower wage inflation.

In the UK, low inflation and low interest rates have driven economic growth and so boosted company profitability
Lower interest rates in the last decade have also helped company profitability to improve through a reduction in interest payments on debt and from a retirement of higher interest rate debt and replacement with lower interest rate debt. Chart b shows that there is a strong link between lower short term The UK is not unique in seeing a sharp rise in profitability, perhaps helped by globalisation, but certainly by lower interest rates and rising labour supply. What does this trend mean for company debt ratings and corporate spreads?

Bond spreads have narrowed, but could widen as investment picks up and interest rates rise
further

UK corporate spreads have narrowed, as a result of lower interest rates and inflation but also due to improved corporate ratings as debt defaults have fallen and gearing ratios have improved. The UK economy is now seeing faster growth, which we think will keep down default rates in the years ahead, see chart c. However, interest rates are likely to rise further and that will put pressure on spreads. Moreover, with economic recovery is likely to come a rise in business investment. That too could push up gearing rates and so widen spreads as ratings are adjusted to reflect a higher liability risk profile.

Overall UK company balance sheets look likely to remain strong
Our conclusion is that low interest rates lead to faster economic growth and together they help firms' profitability and balance sheets to improve. Faster economic growth leads to lower company insolvencies, see chart d, and that will be the key factor keeping down default rates in the next few years in the UK. Economic growth is forecast to be 2.7% this year and 2¾% in 2007 and 2008. But higher interest rates and increased investment should lead to wider corporate spreads. In terms of profits and economic growth, the UK looks in very good shape. In other words, UK bonds look an attractive bet compared with other markets, see chart g, in a global context of rising interest rates and somewhat weaker growth.

Commentary on economic data in the week

Strong US labour market data to force market re-assessment of interest rates


• Unless US GDP growth slows enough to force a drop in core inflation, we believe that US interest rates could rise in Q1 2007, not fall as financial markets are predicting.
• The ECB stays tough on interest rates, even though CPI inflation is slowing. Average eurozone economic growth of 2.5% this year will be strong enough to support higher rates and another 25bp rise to 3.5% in December is a strong possibility.

• A 25bp increase in UK base rates to 5% at the Bank of England’s interest rate setting meeting on 9 November is now virtually a 'done deal' in our opinion, due to the booming housing market, growth in manufacturing and above target price inflation.

• The Bank of Japan will leave interest rates at 0.25% at its rate setting meeting on Friday, as the evidence for inflation is not yet substantial enough to increase them.


Friday’s US labour market data were strong, lessening the prospect of an early cut in interest rates and triggering a rise in the dollar to levels close to $1.25 against the euro as well as increased bond yields. As a result, financial markets reduced their pricing of a cut in US interest rates in Q1 2007 from a probability of 50% to 30%. The data showed that the US economy created an average of 120,000 jobs each month in August and September, with wage growth of 4% in September, an eight year high. The unemployment rate fell from 4.7% in August to 4.6% in September. Our story line goes that strong wage growth and lower unemployment, combined with falling energy prices, could support economic activity in coming months, absorbing some of the headwinds from the weaker property market and leading the US to a soft landing. At the same time, the Fed is clearly concerned about serious inflation risk. In our opinion, unless US GDP growth slows enough to force a drop in core inflation, which rose to 2.5% in August from 2.3% in July, we believe that the Fed will raise US interest rates by a further 25bp in Q1, otherwise it could risk losing credibility. Bear in mind that low inflation is the best way of ensuring steady economic growth. Data this week includes, on Wednesday, the publication of Fed minutes of its 20 September interest rate setting meeting, which will be closely read for further information on the growth and inflation debate. On Thursday, the Beige book will be scrutinised for economic development across the US. Trade data are also published on Thursday – we expect a slight reduction in the deficit to $67bn in August from $68bn in July. Ending the week on Friday, key US consumer data are released, including the University of Michigan consumer confidence data for October and retail sales for September – we expect little monthly change in both.

In the UK, we believe that a 25bp rise in UK interest rates at the Bank of England’s interest rate setting meeting in November is now virtually a done deal. The MPC chose to play the waiting game last week, as members awaited the November Quarterly Inflation report before making up their minds. But whether they needed to is another question. The evidence to justify a move was there for all to see - rising house prices, growth in manufacturing and the likelihood that CPI inflation will be close to 3% in November, the top end of the Bank of England’s target range. The additional risk is that above target inflation may spill over into average earnings growth, making inflation more difficult to manage in future. On Monday, the UK sees the publication of probably lower UK producer prices for September, but this should not preclude the MPC from raising interest rates. UK trade data should show some slight improvement from a deficit of £6.3bn in July to £6.2bn in August, released on Tuesday.

Last week’s ECB interest rate setting meeting showed that members remain tough on interest rates, by hiking 25bp to 3.25%, even though CPI inflation is decelerating. In ECB President Trichet’s accompanying press statement, he refrained from using the word ‘vigilance’, which has been understood to mean that interest rates will be increased next month. However, eurozone growth of 2.5% this year is strong enough to support higher rates and another 25bp rise to 3.5% is a strong possibility in December. In fact, ECB members may see it as a necessary pre-emptive strike.

On Wednesday, eurozone Q2 GDP growth should be confirmed at 2.6% and on Thursday the final German CPI figure for September will come in sharply lower at 1% compared with 1.7% in August.

interest rates and a rise in profitability, with falling rates boosting profitability with a lag. This is reflected in a fall in capital gearing ratios - although a reluctance to invest by companies in the UK has also contributed to a fall in gearing rates, including interest income, as companies have retired debt but have not issued equivalent new debt to match
it.

Trevor Williams, Chief Economist
trevor.williams@lloydstsb.co.uk
www.lloydstsbfinancialmarkets.com
Lloyds TSB Bank,
Financial Markets
Division,
Faryners House,
25 Monument,
London EC3R 8BQ
Switchboard:
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