Article by Michael Lebowitz from RIA Advice cross-posted via Zero Hedge.
A recent whitepaper by the Federal Reserve warns of “significantly lower profit growth and stock returns in the future.” In his article, End of an Era: The coming long-run slowdown in corporate profit growth and stock returns, Michael Smolyansky explains how the interest rate and corporate tax rate trends for the last thirty years provided a strong tailwind for corporate profits. As a result, stocks performed better than would have otherwise been the case.
Understanding why corporate profits and, ultimately, stock prices outperformed in the past is important. However, more critical for investors is the future and assessing how interest rates and tax rates will affect earnings growth and stock prices.
To expand on the article’s warning, we examine a few large well-known companies to see how lower interest and tax rates benefited their bottom lines. But first, we summarize the Fed article.
Key Takeaways
- GDP growth fell markedly over the last 30 years while corporate profit growth rose slightly.
- Lower interest and tax rates and increased leverage greatly benefited corporate net profits.
- McDonald’s, Pepsi, and Clorox support the Fed’s findings.
- Can profits maintain recent growth trajectories without the benefit of lower interest and tax rates?
End of an Era- Article Summary
The graph below shows that corporate earnings have grown faster over the last 30 years than in the 40 years before. The robust earnings growth occurred despite economic growth shrinking markedly.
Michael’s article attributes two key factors to explain the significant disconnect between the two growth rates. Per the article:
My central finding is that the 30-year period prior to the pandemic was exceptional. During these years, both interest rates and corporate tax rates declined substantially. This had the mechanical effect of significantly boosting corporate profit growth. Specifically, I find that the reduction in interest and corporate tax rates was responsible for over 40 percent of the growth in real corporate profits from 1989 to 2019.
Corporate profits would have grown by 4.50%, not 7.76% annually, without the boost from interest rates and taxes, assuming his 40% contribution calculation is correct. Such would be on par with GDP growth for the last thirty years. As we share later, it appears 40% is a reasonable estimate.
Interest Rates
As shown below, Treasury and corporate interest rates have fallen steadily over the last thirty years. As a result of cheap financing, corporate leverage, per the second graph below, has risen substantially to record highs. More leverage and reduced interest costs are a bona fide way to boost profits.
Tax Rates
Per the article:
By 1989, the effective corporate tax rate—measured as aggregate tax expenses divided by aggregate pre-tax income—stood at 34 percent, having fallen from an average of 44 percent over the period 1962 to 1982. From 1989 to 2007, ending just prior to the financial crisis, effective corporate tax rates averaged 32 percent. They then drifted somewhat lower in the years immediately following the financial crisis. The next major step down occurred following the passage of the Tax Cuts and Jobs Act of 2017, which cut the statutory corporate tax rate from 35 percent to 21 percent. With this reform, effective corporate tax rates fell from 23 percent in 2016 to 15 percent in 2019.
The graph below shows effective corporate tax receipts as a percentage of pre-tax income are now around 10% versus 25% in the late 1980s.
McDonald’s, Pepsi, and Clorox
To prove the benefit of lower interest and tax rates, we calculate how they helped improve profits for three large, well-known companies. The table below compares the debt levels, interest, and effective tax rates from 1990 to 2022 for McDonald’s, Pepsi, and Clorox.
All three companies increased their debt load much more than their interest expenses due to lower rates. The effective interest rate decline was significant for McDonald’s and Pepsi. While not as dramatic, Clorox had a meaningful decline. Similarly, the effective tax rates for the companies fell between 15% and 20%.
Lower interest and tax rates had a meaningful impact on earnings, as shown at the bottom of the table. Michael Smolyansky’s estimate that interest and tax rates boosted earnings by about 40% in aggregate seems to be in the ballpark with our analysis. The graphs below the table show the change in interest and tax rates for the three companies over the last 30 years.
Future Interest and Tax Rates
While lower interest and tax rates boosted growth significantly, the ability for that to continue is negligible. The end of a rewarding era for stocks is likely behind us. Given that government deficits will continue to grow faster than the economy, it becomes increasingly unlikely that the government can afford to reduce corporate taxes. In fact, the odds favor raising taxes. Interest rates may fall back to the low levels of the last ten years. Still, unless rates go negative, there is little room on the margin for corporations to reduce their effective interest rate meaningfully.
Consequently, its likely corporate profit growth in aggregate will be closer to GDP growth rates in the future. The gap between GDP and profits we highlighted at the article’s opening will likely close. 4%’ish profit growth isn’t bad. But current high valuations are predicated on solid profit growth. GDP-like growth is not forecasted and will likely weigh on stock prices. Simply put, investors will not be willing to pay an above-average valuation for what will seem like below-average profit growth.
Summary
Per the Fed’s End of an Era article:
It may be tempting to assume that the exceptional stock market performance over the last three decades will continue indefinitely. My analysis, however, indicates otherwise. Both stock returns and corporate profit growth are very likely to be substantially lower in the future. This conclusion follows from the minimal assumption that interest rates and effective corporate tax rates have very little scope to fall below 2019-levels.
The tailwinds of the last thirty years propelling profit growth by about 3% more than GDP are likely over. Without said help, profits are likely to track nominal GDP. However, we must remember that higher interest and tax rates are not out of the question. 4% profit growth may be the upside with a meaningful downside if interest rates stay around current levels and or tax rates increase.
As we wrote earlier:
Simply put, investors will not be willing to pay an above-average valuation for what will seem like below-average profit growth.
About the Author
Michael Lebowitz, CFA is an Investment Analyst and Portfolio Manager for RIA Advisors. specializing in macroeconomic research, valuations, asset allocation, and risk management. RIA Contributing Editor and Research Director. CFA is an Investment Analyst and Portfolio Manager; Co-founder of 720 Global Research.
Follow Michael on Twitter or go to 720global.com for more research and analysis. Customer Relationship Summary (Form CRS)
Two Storms, One Harvest
Every food crisis in living memory has been a one-shock event. The 2008 price spike was a commodity bubble. The 2020 shortages were a logistics failure. The 2022 grain scare was a war on one exporter’s ports. Each time, the system bent, adjusted, and recovered, and each time the experts assured us afterward that global markets are simply too big and too diversified to fail.
What nobody in Washington seems eager to discuss is that 2026 is shaping up to be something the modern food system has never actually faced. Two independent shocks, one climatic and one geopolitical, are converging on the same harvest cycle at the same time. Not sequentially. Simultaneously.
Start with the weather. The Pacific Ocean is currently building toward what forecasters now openly call a record event. NOAA’s Climate Prediction Center puts the odds of at least a strong El Niño near 88 percent, with roughly two in three odds it reaches “very strong” status, the tier reserved for perhaps three or four events in the entire satellite era. Every major global model now projects a median peak in Super El Niño territory, and most of them project it exceeding the 2015-16 event, which until now held the modern record. Sea surface anomalies were already brushing the super threshold in mid-July, months before these events normally peak. The atmosphere has already shifted into El Niño mode, and the event is forecast to crest in late fall and early winter.
This is not about “climate change.” It’s about the standard cycles of weather, and the cycle we’re currently in is one that has likely devastated societies in the past. We’re better prepared as a society today, but not all Americans are equally prepared.
Serious households have started doing the quiet math on their own. Grocery bills tell part of the story, and the forecast maps tell the rest, which is why long-term food storage has moved from fringe hobby to mainstream line item in the family budget, with established suppliers like Heaven’s Harvest seeing demand from people who five years ago would have rolled their eyes at the idea. That instinct is not paranoia. It is pattern recognition, and the pattern is worth walking through carefully.
Editor’s Note: Heaven’s Harvest IS a sponsor, but the warnings of this article are real and would be written even if we didn’t have a survival food sponsor. With that said, those who take advantage of what they offer can use promo code “Patriot” for 15% off.
The Fertilizer Clock Is Already Running
While the Pacific warms, the second shock has been unfolding in the Strait of Hormuz. The conflict with Iran turned the world’s most important energy chokepoint into a contested waterway, and the consequences reach far beyond the gas pump. Roughly a third of global fertilizer trade moves through Hormuz, and the disruption sent urea prices up 86 percent year over year by March, with a 53 percent jump in a single month.
The World Bank projects energy prices rising about 24 percent in 2026 and fertilizer about 31 percent. By its own accounting, fertilizer prices ran 35 percent higher in the first five months of this year than the same period last year.
Here is the mechanism the nightly news will not explain. Fertilizer is not a grocery item. It is a time-delayed input. The nitrogen a farmer in Iowa or Punjab could not afford to apply this spring does not show up as a problem this spring. It shows up as a thinner harvest six to twelve months later.
The World Bank’s own food security brief concedes that the effects of reduced applications earlier this season “are likely to become visible only later in harvest outcomes.” Translate that from institutional language into plain English and it means this. The damage is already done, it is already in the ground, and we are simply waiting for it to arrive on the shelf.
Now check the calendar. Six to twelve months from the spring planting season lands us squarely in late 2026 and early 2027. Which is precisely when the strongest El Niño in the instrumental record is forecast to peak, bringing its signature droughts to Southeast Asia, Australia, southern Africa, northern Brazil, and South Asia, the very regions that grow the world’s rice, sugar, and oilseeds.
The World Bank warns openly that a strong El Niño “could disrupt multiple crop belts simultaneously” on top of the conflict-driven input costs. Their baseline projection assumes the Middle East disruptions ease by autumn. What in the last two years of Middle East history suggests that assumption is safe?
The System Has No Slack Left
The comfortable answer is that global markets always adjust. But adjustment requires slack, and the slack is gone. Global cereal production is expected to decline from last year’s records even before El Niño does its work. The UN World Food Programme, hardly a den of right-wing preppers, is calling this the most significant disruption to its supply chains since Covid and the invasion of Ukraine, and its supply chain director put the stakes bluntly.
Today’s supply chain challenges are tomorrow’s hunger crisis.
There is also a political dimension that markets cannot price. When food gets scarce, governments do not behave like economists. They behave like politicians. Export bans, hoarding mandates, and panic buying at the national level turned the modest rice shortfall of 2008 into a global crisis, and analysts are already warning that import-dependent nations are the first dominoes.
The 2015-16 Super El Niño, a far weaker event than what is now forecast, threw tens of millions into food stress across Africa and Asia. This one is projected to be stronger, and it arrives with fertilizer already rationed by price and shipping lanes already contested by missiles.
What Joseph Knew
Scripture does not treat preparation for lean years as faithlessness. It treats it as wisdom delivered in advance to those willing to act on it.
Behold, there come seven years of great plenty throughout all the land of Egypt: And there shall arise after them seven years of famine; and all the plenty shall be forgotten in the land of Egypt.
Joseph did not respond to that warning with a hashtag or a committee. He stored grain during the years of abundance, and when the famine came, Egypt stood while its neighbors begged. The lesson is not that famine is certain. It is that the time to prepare is precisely when preparation still looks optional.
Nobody who filled a pantry in a year of plenty has ever regretted it, and nobody standing in an empty aisle has ever been glad he waited for certainty.
None of this calls for panic, and panic is the enemy of sound judgment anyway. It calls for the same unglamorous prudence our grandparents considered ordinary. Keep some cash margin, know your local growers, and put real food in deep storage while it is cheap and available, because the entire arc of this story is that cheap and available is a closing window.
Families looking for a straightforward place to start can visit Heaven’s Harvest and use promo code Patriot for 15 percent off long-term storable food. The forecasts may yet soften, the strait may yet reopen, and we should pray they do. But hope is a fine thing to hold and a foolish thing to eat.
