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.
Here’s a typical bottoms up analysis via Bloomberg:
Chief executive officers in America are finding fewer costs to cut, sending profit margins into the first 12-month contraction since 2009 and leaving investors increasingly dependent on economic growth to boost stocks.
Standard & Poor’s 500 Index companies earned $81.93 a share in the last 12 months on sales of $919.39 a share, generating margins of 8.9 percent, according to data compiled by Bloomberg that excludes banks. The measure, a key gauge for investors, slipped from 9.0 percent, the first decline after a three-year, 1.6 percentage point expansion, the biggest ever.
Bears say the contraction shows executives have squeezed all they can from expenses and point out that stagnant profitability accompanied recessions in 2000 and 2007. Bulls say housing and employment data show the American economy is picking up speed and that even if earnings contract, valuations are so low that share prices will build on the 109 percent rally since March 2009.
“Margins collapse when economies are weakening, which is the last thing you want to see,” said Russ Koesterich, the San Francisco-based global chief investment strategist for the IShares unit of BlackRock Inc., on Oct. 24. His firm oversees $3.67 trillion. “That companies remain very profitable has helped support stock prices. If that starts to diminish, it will obviously take away a little bit of the luster.”
I don’t dispute any of the analysis here but it misses the big picture. Namely that when government deficits increase, non-government surpluses increase by the same amount. Here’s something that I think is relevant which I wrote in 2010 arguing why stimulus is no panacea:
“The real problem in countries with high current account deficits like Spain, Ireland, the UK or the US is the lack of household saving and the accumulation of household sector debt. James Carville would say “It’s the debt, stupid.” And I have written two posts with that title in the past, early in 2008 and last September.
“However, in reducing household debt levels, the question then goes to which sector makes the offsetting adjustment: government, the corporate sector or both. Do we even get to decide? In 2008 and 2009, it was the government sector which did the adjusting as we saw a bevy of stimulus measures used to prop up the economy. The corporate sector did no adjusting. In fact, net savings increased as profits have soared post-recession.”
The point: the domestic private sector financial balance is made up of financial balances of companies and individuals both. So to the degree that greater deficit spending drives these balances higher, it could be to facilitate higher household or higher corporate financial balances or both. In this recovery, it has been mostly about corporate balances – and I believe that is because President Obama’s recovery policy has been skewed toward the corporate sector over the household sector. We can debate the merits of that skew, but the consequences are plain in terms of record corporate profits despite the tepid recovery.
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.