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Government deficits are the biggest driver of elevated corporate margins

I think it goes without saying for those of you who have been using the sectoral balances approach, government deficits are what have been driving corporate profits in the U.S. to record levels. Most analysts and news outlets focus on the micro factors, using a bottoms-up approach. But, looking at it top down from a macro perspective, it is significant to realise tha government is driving the profit bus because this means austerity will kill margins.

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There are two conclusions we should make. First. since profit margins are mean-reverting due to the micro factors mentioned in the Bloomberg article, we should expect them to come down now. And we are seeing this, even without recession. However, for margins to collapse, you need a macro event to cause this shift. And the macro event that we should be looking for is a net reduction in public sector deficits. Not only will this reduce GDP, it will also have an extremely negative effect on corporate margins and profitability in the US – just as deficit reduction in Europe has hurt U.S. multinationals already. When the U.S. turns to a similar policy response, the right investing approach is to reduce risk and become more defensive, if not move to a more speculative net short position. Government deficits are the biggest driver of today’s high corporate margins, when those deficits go down, so too will margins.

About 

Edward Harrison is the founder of Credit Writedowns and a former career diplomat, investment banker and technology executive with over twenty years of business experience. He is also a regular economic and financial commentator on BBC World News, CNBC Television, Business News Network, CBC, Fox Television and RT Television. He speaks six languages and reads another five, skills he uses to provide a more global perspective. Edward holds an MBA in Finance from Columbia University and a BA in Economics from Dartmouth College. Edward also writes a premium financial newsletter. Sign up here for a free trial.