As US Economy Plods and Pay Lags, Companies Profit

Look at the U.S. economy and you'll notice an unusual disconnect.

The economy is being slowed by a tight job market, scant pay raises and weak business investment. Yet corporate profits are reaching record highs and fueling record stock prices.

What gives?

How are companies managing to earn so much money in a sluggish economy? And why aren't their profits goosing the economy?

For starters, weak job growth has held down pay. And since the recession struck six years ago, businesses have been relentless in cutting costs. They've also stockpiled cash rather than build new products or lines of business. And they've been earning larger chunks of their profits overseas.

All of which is a recipe for solid profits and tepid economic growth. The economy grew at a meager annual rate of just 1.8 percent in the first half of 2013. The unemployment rate is 7.2 percent, far above the 5 percent to 6 percent considered healthy.

Even so, corporate profits equaled 12.5 percent of the economy in the April-June quarter, just below a 60-year high reached two years ago. Profits of companies in the Standard & Poor's 500 have nearly doubled since June 2009. Earnings appear to have risen again in the July-September quarter.

Big companies like Kellogg, FedEx and Best Buy have been slashing costs in the face of slowing revenue. Their strategy has been working: Despite sluggish revenue, their profits are up.

Burger King's sales dropped last quarter as competition intensified. Yet the company's earnings surged because it cut expenses and enjoyed growth overseas.

"Corporations have more market power than workers have and have kept wage growth to subdued levels," says Dean Maki, an economist at Barclays. "That's left more for corporate profits."

Those solid earnings have helped boost stock prices. So has the Federal Reserve's drive to keep long-term interest rates near record lows: Lower bond yields have led many investors to shift money out of bonds and into stocks, thereby boosting stock prices.

The Dow Jones industrial average has jumped nearly 20 percent this year, closing at 15,639 on Monday, just below its record high.

"If we ended the year at these levels, it would be a phenomenal year," said Bob Doll, chief equity strategist with Nuveen Asset Management.

Here are factors economists cite for the gap between healthy corporate profits and subpar economic growth:

- FLAT PAY

Wages and salaries equaled just 42.6 percent of the economy in the April-June quarter, near a record low set in 2011.

More than 8.5 million jobs were lost in the recession and its aftermath, leaving workforces leaner and more productive. Corporate revenue rose as the economy recovered.

But workers haven't benefited much. With unemployment still high, they've had little leverage to demand higher pay. Many have been happy just to have a job.

"We've just had a very lopsided economic recovery," says Ethan Harris, an economist at Bank of America Merrill Lynch.

Smaller paychecks have deprived Americans of money to spend. In the 30 years before the recession, consumer spending grew an average of 3.4 percent a year. Since 2010, just after the recovery began, it's risen just 2.2 percent a year.

"If workers don't have any money, businesses don't have any customers," says Nick Hanauer, an entrepreneur who has written about U.S. economic disparities.

The stock market's gains have boosted total U.S. household wealth. But they haven't enriched most Americans. The wealthiest 10 percent of households own about 80 percent of stocks.

- COST CUTTING

This week, Kellogg said it would cut about 7 percent of its workforce - 2,200 jobs - by 2017. The cuts are part of a "global efficiency and effectiveness program," the company said.

Even though Kellogg's sales were flat in the July-September quarter compared with a year earlier, it squeezed out 2.5 percent more net income. A key factor: It cut administrative and borrowing costs. Its shares have risen 15 percent in the past year.

FedEx is cutting jobs, too. And though its quarterly revenue rose just 2 percent, its earnings grew 7 percent. The company has cut maintenance costs by replacing older aircraft with more fuel-efficient planes. The shift helped reduce maintenance costs 11 percent in the June-to-August quarter.

The new planes are merely replacing older aircraft rather than expanding FedEx's fleet. So the economy doesn't stand to benefit as much.

The average sales growth of an S&P 500 company was 2.35 percent in the first six months of 2013, down from 3.76 percent in 2012, according to S&P Capital IQ. The average profit margin for an S&P 500 company widened from 8.1 percent to 9.1 percent in the same period.

- CASH HOARDING

Higher profits could help the economy if corporations plowed them back into new plants, equipment and other projects. That hasn't happened.

"Corporations have been extremely cautious in their spending in this recovery," said Maki of Barclays.

Business spending on big-ticket items like computers, industrial machinery and capital goods has remained about one-third below the average in previous recoveries, Harris estimates.

Instead, companies have stockpiled a record $1.8 trillion in cash, according to the Fed, up nearly 10 percent since the recession ended in 2009. And thanks to the Fed's drive to keep rates low, big companies have been able to borrow cheaply and replace their higher-cost debt.

All that has bolstered corporate finances and helped boost stock prices even though companies remain reluctant to expand.

Improved finances are "great for the company and its stock price, but from the point of view of the broader economy, you'd prefer they use the money to hire more workers and invest in more projects," Harris says.

Why are companies holding back?

Economists say chronic budget fights in Washington and Europe's financial crisis have left executives uncertain about the economy and reluctant to commit to big projects. So have the uncertain consequences of the Obama administration's health care law, said Mark Vitner, an economist at Wells Fargo Securities.

- GLOBALIZATION

Rising international competition has lowered wages as a share of the economy in most developed countries, according to the Organization of Economic Cooperation and Development, a think tank in Paris. About one-tenth of the decline is due to competition from lower-wage countries, the OECD found.

And big U.S. companies are earning a larger share of their sales and profits overseas than in previous decades. That means their profits and stock prices can grow even when growth in the United States is weak.

Apple produced 58 percent of its sales outside the country in its 2013 fiscal year. ExxonMobil, the world's largest company, earned roughly 80 percent of its profits after taxes outside the United States in its 2012 fiscal year.

Nearly half of all sales earned by companies in the S&P 500 index - 46.6 percent - are produced outside the United States. In 2003, the figure was 41.8 percent.

Aswath Damodaran, a professor of finance at New York University's Stern School of Business, notes that the trend is a global one.

Many Indian companies have fared well in recent years even as India's economy has slowed. French luxury goods company LVMH did only a tenth of its sales in France in 2013.

"It used to be that U.S. companies lived off the U.S. economy and French stocks lived off the French economy," Damodaran said. "Now, stock markets are more reflections of the global economy."

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Sweet reported from New York. AP Business Writer David Koenig contributed to this report from Dallas.