There’s been a lot of discussion here and from many different analysts regarding the potential for a future decline in corporate profits. One of the points I’ve been highlighting is the importance of government deficits in driving corporate profits in recent years based on an understanding of Kalecki. In an essay today (thanks to John Carney) Neel Kashkari of PIMCO highlights some of the risks to corporate profits and does a bit of Kalecki:
“To assess the vulnerability of profit margins, let’s review several possible catalysts for profit mean reversion and consider how likely they are to occur:
1. Increase in Cost of Labor
Labor costs are about 70% of the total cost of production for corporations, according to Federal Reserve research. There is no question that if competition for a finite labor pool increased, this could put immediate pressure on corporate margins. However, in the U.S. unemployment remains high, stuck at 8.2% as of March 2012, with 14.5% of Americans either out of work or looking for more work (source: Bureau of Labor Statistics). Obviously individual industries and companies may experience wage inflation due to scarcity of workers with specialized skills, but until unemployment falls closer to more normal levels, corporate margins do not appear vulnerable from a spike in unit labor costs. Last week’s disappointing jobs report highlights labor’s slow recovery.2. Economic Slowdown or Recession
Clearly if the U.S. or world economy were to meaningfully slow or fall into another recession, corporate profits and stock prices would suffer. Our base case continues to be a muddle-through scenario of low growth while avoiding recession in the U.S. and globally (though we do forecast a recession in Europe due to their fiscal crisis and policy response). Certainly a disorderly unraveling of the eurozone, an oil price shock or a hard landing in the emerging markets could tip the global economy into recession, but that is not our central scenario.
3. Dollar Strengthening
Strong appreciation of the dollar would make U.S. exporters less competitive, which would certainly affect their margins. But companies producing goods and services abroad for sale in America would benefit. Our base case scenario is for a long-term secular decline of the dollar, which assumes continued strengthening of emerging market economies and a Europe that muddles through its fiscal crisis. If either proved incorrect, they could trigger a global recession, which would have a larger impact on corporate margins than dollar strengthening alone.
4. Cost of Capital Increase
If costs for corporations to borrow or to raise equity capital increased substantially, corporate margins would be vulnerable. Corporations today on average have low net leverage with record cash of some $2.23 trillion, according to Federal Reserve data. Climbing rates could pressure corporate margins. They could also push companies to grow more slowly or even contract their activities. Again, this is not our central forecast. We believe the Federal Reserve will stick to its forecast of maintaining exceptionally low rates until at least late 2014, and we believe the European Central Bank will be forced to continue aggressive monetary stimulus to combat its fiscal crisis. It is worth noting that corporations could in fact increase their net leverage from today’s conservative levels, which could actually boost corporate margins.
5. Increased Corporate Taxes
If the federal government increased effective taxes on corporations their net margins would obviously fall. But this appears highly unlikely in today’s political environment. Both Democrats and Republicans are advocating various policies to boost job growth, including pro-growth corporate tax reform. The most common tax reform proposals are revenue neutral, lowering marginal corporate tax rates in exchange for eliminating loopholes and deductions. Policy theory suggests a simpler, fairer tax code should encourage investment and enhance economic competitiveness. While political winds can change direction, as long as unemployment remains high, politicians will be cautious about increasing barriers for corporate investment.
None of these catalysts for profit mean reversion appears likely in the near future, though each is impossible to rule out. Given the importance of corporate margins on today’s stock prices, it is worth taking this review further and also considering a macroeconomic perspective on margins.
Some investors have used the Kalecki profits equation to break corporate profits into its fundamental macroeconomic elements, specifically:
Profits = Investment – Household Savings – Government Savings – Foreign Savings + Dividends
From this equation, investors can see that corporate profits have expanded to such a large share of GDP due to large government deficits. Therefore, if the government implemented a deficit reduction plan, corporate profits could suffer.'”
That’s a nice summary. The CBO is currently predicting a substantial decline in the deficit in 2013. It’s impossible to know whether this will turn out to be accurate or not. But the risk is certainly present….
Mr. Roche is the Founder and Chief Investment Officer of Discipline Funds.Discipline Funds is a low fee financial advisory firm with a focus on helping people be more disciplined with their finances.
He is also the author of Pragmatic Capitalism: What Every Investor Needs to Understand About Money and Finance, Understanding the Modern Monetary System and Understanding Modern Portfolio Construction.
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