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Hello and welcome to Notes in the Week Ahead, a JP Morgan Asset Management podcast that provides insights on the markets and the economy to help you stay informed in the week ahead. Hello, this is David Kelly. I'm Chief strategist here at JP Morgan Asset Management. Today's July 20, 2026 the earnings season has started with a blast. As Of Friday morning, 49 of the S&P 500 companies had reported second quarter earnings with 85% beating expectations and the index on track for a blockbuster 23% year over year gain for the quarter. According to FactSet, analysts now expect S&P 500 operating earnings to reach $340.74 for 2026 as a whole, up 24% from 2025, following back to back strong gains of 10% and 13% in 2024 and 2025 respectively. This profit surge is normally analyzed in terms of companies and sectors, and recent gains look particularly concentrated with 10 companies, mostly in tech, accounting for 75% of the expected growth in second quarter earnings. When questions are asked about the sustainability of the profit surge, the investigation usually centers first on whether genuine revenues from AI technology can ramp up fast enough to justify current capital spending, and second on how broadly the ripple effects of AI investment, spending and wealth creation could ripple out across the economy. However, profit growth has been outpacing overall economic growth for decades, and a top down macro perspective can also be useful in identifying the broader forces that have fueled this surge. In broad terms, profit growth has been powered by the ability of US Firms to control compensation costs while taking advantage of a more favorable interest rate and tax environment. This begs the question of whether these beneficial forces can continue and whether other broad forces might slow or reverse the profit surge. A top down view of profits starts with the adjusted after tax profits of all US Corporations as compiled by the Bureau of economic analysis. From 1947 to the mid-1990s, this measure of profits hovered in a narrow range around 6% of GDP. Since then, despite sharp swings through recessions and recoveries, this ratio has trended higher, hitting a peak of 11.5% of GDP in the fourth quarter 2025 before easing back slightly to 11.4% of GDP in the first quarter of this year. As a result, over the past 30 years, while nominal GDP has grown at an annual pace of 4.8% adjusted after tax, profits have grown at a 6.3% rate. This profit surge has provided a strong foundation for a rising stock market and those of us who have lived and worked through these boom years for stocks you can easily think of the trend in terms of favored industries tech, energy, housing, financials, and then tech again. However, the profit surge can also be examined through a different lens. The after tax profit share of national income Its slice of the pie, so to speak, has grown because other slices have been squeezed. These include worker compensation, both in the form of wages and benefits, net interest costs and corporate taxes. Depreciation expense, conversely, has gradually risen. Looking forward, while economic growth will be determined by trends in the workforce, productivity and inflation, the growth in profits will also depend on whether the corporate profit share of the economic pie continues to rise. This, in turn depends on the other slices. In the first quarter of 2026, the adjusted after tax profits of all U.S. corporations amounted to $3.624 trillion at an annual rate, or 11.4% of GDP. That was up 5.9 percentage points from an average of 5.5% of GDP in the decade that ended in the fourth quarter of 1994. But if the profit share was up, what was down? The most obvious answer is worker compensation, which fell from 55.7% of GDP to to 50.5% over the same period. The compensation share of GDP rose through the 1950s and 1960s, declined a little for the rest of the 20th century, and has fallen sharply over the past 25 years. However, the trend is much more dramatic when compensation is broken down into wages and benefits. Wages peaked at 51.9% of GDP in the first quarter of 1970 and have fallen sharply ever since, reaching just 41.6% in the first quarter 2026. Over the 1970s and 1980s, this trend was somewhat offset in corporate income statements by fast rising benefits. This in turn reflected union success in pushing for enhanced benefits in general, as well as soaring medical insurance costs and the increased cost of funding to find benefit pension plans. However, in recent years, companies have had some success in restraining the growth in benefits. In the 20 years from 1986 to 2006, insurance benefits, mainly health insurance, rose from 5 1/2% of total compensation for private sector workers to 7.4% over the last 20 years, despite an aging workforce and a growing number of available but expensive treatments and drugs. This has risen more slowly to 7.8% over the past 40 years. The cost of retirement contributions has also fallen from 3.8% of compensation to 3.4% as businesses have transitioned from defined benefit plans to less expensive defined contribution plans. Workers comp contributions have also fallen steadily from 2.3% of total compensation in the first quarter of 1993 to just 0.9% in the first quarter of this year, reflecting fewer workplace injuries and state level reforms. The decline in labour compensation as a share of GDP may reflect a long and steady decline in union power, with the unionized share of private sector workers having fallen below 6%. Or it could be that management has just become much more skilled at deflecting wage and benefit demands over the years. Whatever the reason, there's little sign that this trend is reversing. Even with a very tight labour market, the real wages of production workers fell on a year over year basis for a third consecutive month in June. Moreover, strike activity remains very muted with only 16 major strikes in the first half of 2026, far below the average of almost 300 strikes per year seen in the 1970s. Given this, and with the threat of replacement by AI now taking over from the threat of replacement by foreign workers, the most likely scenario is for a continued slow decline in the compensation share of national income, thereby boosting corporate profits. A second important tailwind for after tax profits has been falling effective tax rates. At first glance, this isn't obvious from the data. The Corporate Tax Rate Corporate tax share of GDP actually rose from 2.1% in the decade that ended in the fourth quarter 1994 to 2.5% in the first quarter 2026. However, corporate taxes have not risen nearly as fast as the profits being taxed. The average effective tax rate on corporate profits fell from 28.1% in the decade that ended in the fourth quarter 1994 to 18.1% in Q4 2026. To put this in perspective, as noted earlier, adjusted after tax profits have risen by 6.3% per year over the past 30 years. However, if effective corporate tax rates had not fallen, that number would have only been 5.9%. This falling corporate tax burden has been the result of major legislation, including the 1981 Tax act, which introduced accelerated depreciation and expanded investment tax credits the 1986 Tax act, which cut the statutory corporate tax rate from 46% to 34% the 2017 Tax act, which cut the statutory rate further to 21% and the 2025 act, which restored immediate expensing of R and D and equipment purchases. Effective rates fell by less than statutory rates over this period, partly because of base broadening efforts and also due to the introduction of an alternative minimum corporate tax in 1986, which was repealed in 2017 but then revived in 2022. In general, Washington has been very kind to shareholders in recent decades. Both in relation to declining corporate taxes and lower taxes on dividends and capital gains. Will this continue? There are some headwinds in the short run. First, corporations appear to be absorbing much of the cost of new tariffs introduced since 2025. Between December 2024 and June 2026, import prices for goods excluding food and energy, which are calculated before tariffs, rose by 4.8%, while consumer prices for goods excluding food and energy, which include the cost of tariffs, rose just 1.5% over the same period of time, the average effective tax rate on imported goods climbed from 2.6% to 7.6%. Now, if foreign producers had been absorbing the full cost of the tariffs, then import prices would have fallen over this period and they didn't. If companies were passing most of the cost of the tariffs onto consumers, the increase in post tariff consumer prices for core goods would risen faster than pre tariff import prices. The fact that neither of these things happened suggests that while US Companies are pretty good at restraining compensation, they're not nearly as successful at passing on higher cost to consumers. While we don't expect tariff rates to rise significantly in the near term, this is something to consider if for some reason Washington doubles down on using tariffs as a source of revenue in the future. Second, it should be noted that much of the corporate tax benefit from OEBA was in the form of the reintroduction of 100% expensing on R and D equipment purchases. However, estimates of the cost of these provisions show the biggest tax break for companies in fiscal 2025 and 2026, with diminishing impacts thereafter. After all, a firm that expenses capital spending in year one can't then depreciate the same investment for tax purposes in future years. Finally, there may be a risk that the federal government will look to corporations to plug part of a growing budget gap, with the federal deficit now on track to top $2 trillion this year, and federal debt expected to rise from 100% of GDP currently to well over 120% by the middle of the next decade. All of this being said, in the current American political climate, corporations may well be successful in lobbying for continued low corporate tax rates even as the fiscal situation deteriorates. Money has never been more powerful in US Politics than it is today, and armed with the tools of social media and artificial intelligence, is more capable of defending corporate interests than ever before. All this being said, there are also some real challenges to the corporate profit surge. One of them is interest expense. The data on corporate interest expense in the national income and product accounts is muddied by the treatment of owner occupied housing and financial corporations. However, a clearer perspective is provided by the interest expense of S&P 500 companies. As a share of sales, this ratio rose from 3.0% in the first quarter 1996 to 5.7% in the third quarter 2007 and the peak of the housing bubble. It then fell steadily to just 1.4% by the end of 2021, but has since risen to 2.4%. From here it's likely to rise further, reflecting new corporate debt issuance to pay for the AI buildout. In addition, the Moody's BAA corporate bond yield as of last Thursday stood at 6.16%, 159 basis points above the 10 year treasury yield of 4.57%. We expect treasury bond yields to move up on average in the years ahead due to increased government debt issuance, while the spread between corporate yields and treasury yields is now tighter than it has been 85% of the time over the past 50 years and could therefore be expected to widen going forward. Finally, with corporate bond yields significantly higher than in the decade after 2012, the gradual replacement of old debt with new debt should raise interest expense and then there's the issue of depreciation. There is of course the current very specific question about how rapidly hyperscalers should depreciate their investments in semiconductors. Given the rapid product cycle of cutting edge GPUs, accounting at both the corporate level and in the national income product accounts may be using a too slow depreciation schedule and consequently may be overstating current corporate profits or with the real risk of greater overstatement in the years ahead. However, even ignoring this issue, measured depreciation of business fixed assets has been trending up for decades and it's likely to accelerate over the next few years due to increased capital spending. As just one measure of this business fixed Investment rose to 14.1% of GDP in the first quarter this year. It's the biggest share of GDP in 25 years and we expect it to continue to grow fast in the overall economy until the next recession. While this is generally a very positive trend, it could of course be very negative for corporate profits if for some reason AI revenue growth were to slow even as depreciation expense rises. There are at least two other major issues that will impact profit growth going forward. First, the foreign profits of US based companies should continue to rise and may well receive a boost from a falling dollar over the next few years. Second, overlaying all of this are the productivity gains expected from AI. In a world in which companies continue to be able to hold wages in check, corporations may garner an outsized share of these efficiency gains. Pulling all these strands together until the next recession, it looks likely that profits will continue to rise a little faster than the overall economy. That being said, even in a continued economic expansion with little political change, rising interest rates and depreciation expense should slow the pace of profit growth. Moreover, it's always possible that there will be radical political change with some future administration seeking to boost wages and limit the rise in federal debt by imposing higher corporate taxes. This risk, like many others, suggests that even with a still benign base case outlook for corporate profits, investors should still consider rebalancing portfolios that have drifted into being overly concentrated and overly aggressive. Well, that's it for this week. Please tune in again next week and if you have any questions in the meantime, please reach out to your JP Morgan representative.
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