Wednesday, 8 April 2015

Guest Post - US Corporate Profits Under Threat

"Human behavior flows from three main sources: desire, emotion, and knowledge."- Plato
Please find below a great guest post from our good friends at Rcube Global Asset Management. In this post our friends go through the numerous factors pointing towards corporate profits in the United States surprising on the downside in coming quarters:

Michal Kalecki was a Polish neo‐Marxist economist who, during the mid‐30s, undertook the difficult task of explaining why, contrary to Marx’ predictions, corporate profit rates in capitalist societies were not converging towards zero.

The starting point of his argument lies in the fact that an economy can only save (i.e. increase its aggregate wealth) by investing. Kalecki’s profit equation therefore begins with the following equation:

Saving = Investment

If we divide saving into Business Saving (= Profits after taxes and dividends) and Non‐business saving (Personal saving + Foreign saving + Government saving), the equation becomes:

Profit after taxes and dividends = Investment ‐ (Household + Foreign +
Government) savings

=> Profit after taxes = Investment + Dividends ‐ (Household + Foreign + Government) savings

The Kalecki profit equation is not a mere macroeconomic model. It is an accounting identity that remains true at all times. One can always verify its validity by checking the following items in the National Income and Product account.

Interestingly, the Kalecki equation implies the following paradox: although the business sector often advocates for balancing governments’ budgets, the Kalecki equation undeniably shows that a large part of corporate profits actually derives from budget deficits. It has certainly been true over the last 70 years.

Following Kalecki’s equation, the fiscal cycle can be used as a lead indicator for corporate profits and the business cycle.

In a recently published piece, John Hussmann explains that because in the US, investment,dividends and foreign savings usually cancel each other, the Kalecki equation can be reduced to:

Corporate profits = ‐ (government + household savings).

In recent years, this has however not been the case. Investment rose while the current account improved (imports‐ exports= foreign savings). Therefore, as the chart from Hussman’s blog shows, the relationship broke down over the last 5 years.

- source Hussman funds

This explains why, despite reduced savings from the combined government and household sectors, profits have held up quite well. Part of the answer comes from quantitative easing. Debt issuance to repurchase shares has artificially lifted profits. Additionally, the last few years also correspond to the shale oil revolution. It is therefore possible that with a lower energy bill, the US was able to “self‐finance” investments without the usual help of imported foreign savings. The question is, can that last now that QE is over and with the FED about to lift interest rates? Given the strength of the dollar and the weakness of the global economy, the most likely scenarios are that investment weakens and/or that the current account improvement goes into reverse. Already, capital goods’ spending is weakening, and the oil crash has increased the odds that it will weaken substantially more.

Furthermore, over the last 3 years, consumers have tapped into their savings. The saving rate went from a high of 8.5% in 2012 to 4.5% today. It is unlikely that the saving rate will drop further given 1/ the close memory of 2008 2/ demographics 3/ current households behavior (consumer are using their strong cash flows to pay down debt).

At more than 600% of GDP, the US government + unfunded off balance sheet debt leaves no options on the fiscal side of the Kalecki equation when the cycle turns.

As a result the boost to private consumption from consumers is unlikely to be repeated. And since government dissaving has more than offset consumer spending it is likely that profits will surprise on the downside in coming quarters. Even more so, if investment weakens on top.

We can also observe a strong link (with a lead) on both corporate credit spreads….

and thus equity volatility.

As we have shown recently, the strength of the US currency is another threat to corporate profits and forward earnings estimates. When the supply of dollars globally shrinks (budget and current account improve together) overseas earnings tend to crash, hence the relationship below.

Current consensus believes that extremely low yields and energy prices will more than offset these threats.

With US equity volatility as mispriced as it was back in 2007 according to our model, now is not the time to be overly complacent.

Finally we would like to also add an important point made by David Goldman which can be found on Reorient Group's website from his note from 31st of March entitled "US Corporate Profits Inflated by Undersestimated Depreciation":
"If the United States wants to attract Chinese investors, it had better improve accounting standards. That sounds like the beginning of a joke, but it’s not. There have been isolated cases of accounting fraud in Chinese companies listed on US exchanges, but there appears to be systematic distortion of US corporate profits across the board. The issue is depreciation of plant and equipment. This is another reason we don’t like US stocks at present valuations.
Before-tax earnings of US companies in the GDP accounts are reported two ways: with Inventory Valuation Adjustment (IVA) and Capital Consumption Allowance, and without. The two measures have diverged by about 25%, or US$500 bn, since 2012. That’s a big divergence. The stricter measure (based on the Commerce Department’s depreciation model) shows that Q4 corporate profits in 2015 were lower than in Q4 2011; the looser measure shows substantial growth. Note that the S&P 500’s earnings per share track the higher, not the lower number."
- source Reorient Group

"When growth is slower-than-expected, stocks go down. When inflation is higher-than-expected, bonds go down. When inflation is lower-than-expected, bonds go up." - Ray Dalio

Stay tuned!

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