Jeremy Beckwith: Low growth and low inflation can be rewarding

THIS year, stock market earnings per share in the United States and the UK are expected to be only a little below the records set in 2007, and analysts are confident that 2011 earnings will exceed those records.

What makes this even more impressive is that this is an industrial company phenomenon - banks are reporting large profits thanks to zero interest rates, but their earnings per share are a fraction of the record levels of a few years ago due to the huge increase in the number of shares they have had to issue to repair their balance sheets. Industrial corporate profit margins, meanwhile, are near 60-year highs.

The key reasons for companies doing so well lie in the balance of power between them and their workers and between them and governments.

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First with regard to labour, the introduction of both India and China into the workings of the global economy has led to hundreds of millions of new unskilled or semi-skilled workers, and tens of millions of good-quality graduates, entering the global labour market. Many jobs previously filled by western workers are being lost to Asia as labour costs there are so much lower. Initially these were manufacturing jobs, but in a knowledge-based economy, many high-skilled, graduate level service-sector jobs are just as transferable.

Thus, western wages have barely grown in real terms over the past decade and all the value created by the growth of the economy has accrued to the companies and their top managers, who continue to expand the multiple of earnings of their average worker that they themselves make.

Secondly, it is very apparent that governments realise their dependence on companies for growth in the next few years. The levels of debt and budget deficits mean that politicians now clearly understand that future jobs, and with them their nation's prosperity and thus their own political hopes, can only come from the corporate sector. Thus companies are not being taxed more in an effort to repair government finances, and any company planning to create jobs will find itself being fted.

At a time of low global inflation, strong profits translate into healthy cash flow, giving companies the options of strengthening their balance sheets further, rewarding shareholders with dividends and buying shares (their own or shares of others in takeovers) in the market, or investing for future growth. To date in this recovery, corporate cash flows have gone into building stronger balance sheets - an understandable response, as it has become clear that the banks will not be in any position to fund growth.

Rewarding shareholders is beginning to attract the interest of some management teams, though more by way of takeovers. Since the summer, takeover activity has been rising, although mostly in the resource and technology sectors representing two sectors going through key secular changes.

Dividends are well covered by earnings and look likely to do well next year.There is, however, very little evidence that firms are keen to use their cash to fund investment for growth. Perhaps the best explanation is that although their average return on capital is currently high, the marginal return on capital (that is the return on the next bit of capital invested) is perceived to be too low, and certainly lower than the cost of that capital. It then becomes rational not to invest, despite being very profitable. The reasons for a poor marginal return on capital are easy to see - a government sector cutting back on its consumption, an over-leveraged consumer sector keen to boost savings, and a world in which everyone is seeking export-led growth.

Over the next year or two this could be a powerful mix for financial markets, as companies will focus on strengthening balance sheets, boosting dividends or making share buybacks that enhance earnings. If companies can maintain margins, then an era of low growth and low inflation can still be rewarding to owners of equity and corporate debt.

• Jeremy Beckwith is chief investment officer at wealth managers Kleinwort Benson.