A look back

bubblesvoltaireInternet and Web Development

Nov 10, 2013 (3 years and 7 months ago)

77 views

Stunning growth in corporate profits
has been a defining feature of the U.S. financial
landscape during the past f
ive

years. And the third quarter of 2006 has been no exception.
It looks like S&P 500 companies grew their operating earnings by 1
x
% in the th
ree
months
ending in September 2006
, continuing a string of
seventeen
consecutive quarters
of double
-
digit EPS growth. The big question now is: How long can this rapid growth
continue?

Our answer is: not very much longer!

Below, we describe a framework tha
t we hope helps to explain and understand the surge
in profitability in the United States since the 2001 recession. And with this framework, we
believe we can make some informed judgments about the sustainability of the current
earnings growth path. Based
on the so
-
called neo
-
classical synthesis of Keynes’
General
Theory,

total income {Y} in an economy can be thought of as the summation of consumer
spending {C}, investment spending {I}, government spending net of tax receipts {G
-
T}
and net exports of goods
and services {X
-
M}. Income {after
-
tax} can be thought of as
either personal income {W} or corporate profits {P}. So to turn our focus exclusively on
profits {P}, we can “subtract” personal income from “both sides” and write the national
income accounting i
dentity as:

P = {C
-
W} + I + {G
-
T} + {X
-
M}

Put in words, changes in after
-
tax profits in the U.S. economy are driven by changes in
household

saving {C
-
W}, changes in
investment

spending
, changes in the government
budget deficit, and changes in the trade bal
ance. We think this identity reveals some
interesting truths. First, a decline in the household saving rate {
consumption (
C
)
growing
faster than

wages (
W
)
} is good for corporate profits. So too, is a growing government
budget deficit. This is because both
imply spending {or its equivalent, corporate revenue}
is increasing without an associated increase in costs to business
--

either
higher
wages
and/or
higher
taxes.

Increasing investment spending is seen to be unambiguously positive for profits. This is at
the heart of Keynes’ analytical framework in the
General Theory

--

the key here is that
causality runs from investment to profits, not the other way around. And finally, a
growing trade deficit is clearly bad for U.S. profits, since it implies a leakage o
f spending
{and with it, potential profits} to non
-
U.S. producers of goods and services. That is our
profit accounting framework. Now lets plug in some

some of the

“old” numbers.

A look back

From the start of 2002 to the beginning of 2006,
consumer spendi
ng in the U.S. increased
by $1.69 trillion {or 5.5% per year} while disposable personal income rose by $1.55
trillion {or 4.9% per year}. The difference between these two figures
represents
a decline
in household saving of $140 billion. The underlying tren
ds


household spending growing
faster than incomes


were a plus for corporate profits. During these same four years,
investment spending rose $440 billion {or 6.1% per year} providing a huge boost to
profits. Of this measured increase in fixed investment
, 6
8
% {$
300

billion} has gone to
housing and 3
2
% {$1
40

billion} has gone to new business equipment and structures.

As with
households, spending at all levels of American government grew faster than
income {
that is
tax receipts} during the past four years,
and the budget deficit expanded
by $3
65

billion. The widening budget deficit provided another major boost to profits. But
there was one enormous drain on domestic income

and negative for corporate profits



the
trade deficit widened by $
350

billion
in the

four years ending in 2005
. So if we sum up
these four pieces, we get a

“target”

increase in after
-
tax profits of $5
95

billion, or a
compound growth rate of 2
2
% per year for the four years

ending in 2005
. The actual
number published in the Federal Reserve
’s
Flow of Funds

accounts is $
615

billion, a
difference of $
2
0 billion … not bad for government data!

What happens next?

So much for the past … what about the future?
We know that
Americans have become
accustomed
or even addicted
to growing their spending

faster than their incomes. And no
wonder, it feels great. But
interest rates are higher now than
they were
a couple of years
ago. And
more importantly,
home prices are falling. When home prices are appreciating
each year at a rate faster then the level o
f interest rates, Americans tend to borrow and the
saving rate falls


but now the opposite is the case, and the saving rate is starting to rise
.

(For a lucid exposition of past and likely future trends in household saving in America see
Martin Feldstein’
s essay
The Return of U.S. Saving

in the May/June 2006 issue of
Foreign Affairs
.)

So instead of saving declining by, on average, $35 billion per year as it has during the last
four years, lets assume that it rises by $
3
5 billion
in

2007
--

that would happe
n if
consumer spending grows by 5.
3
% per year, and disposable incomes grow by 5.
5
% per
year … not very radical assumptions. The net result would be increased household saving
that would reduce the level of after
-
tax profits by $
35

billion
in 2007
.

Animal
spirits

Capacity utilization is comfortably high in many U.S. manufacturing industries, and with
global growth
pretty
strong, export prospects look good for those industries with products
that can compete in foreign markets like aircraft, construction and
farm equipment.
Energy companies of all stripes are ramping up investment too. But some domestic
industries are getting hammered {like autos} and others are seeing orders slow sharply
{like computers}, so a good working assumption may be that business inve
stment
spending will grow modestly faster than the overall U.S. economy next year


we’ll
assume 7.0%
.

If that i
s the case, investment in plant,

equipment
and inventory
will rise by
$
100

billion next year.

Unlike business investment, residential investment

is starting to decline

in 2006
.
How
severe will the housing decline be? No one really knows. But to continue our exercise,
let’s assume residential investment falls back to its “average” level of 4.7% of GDP by the
end of 2007.
That would imply a fairly
gentle “correction”
by
historic
al standards
--

residential investment usually bottoms at a much lower share of GDP. But such a pull
back would still imply a 1
5
% decline {or $1
15

billion} in residential investment
next
year
.

Uncle Sam, and the mother of
all trade imbalances

The broad contours of government spending and revenues are pretty clear. After growing
very rapidly during the past few years, the pace of government spending is now slowing
to a growth rate broadly in line with that of the overall ec
onomy. At the same time,
revenue growth is picking up steam {more capital gains and a modestly higher corporate
tax rate}. So revenues {taxes} are now growing faster than GDP.

With a split government (Democratic Congress, Republican President) in Washing
ton, it
is unlikely that anything dramatic happens to Federal tax or spending policies in the next
year or two. S
o it seems fair to assume that existing trends will stay in place. If that’s the
case, the overall government budget deficit {including state &

local governments} is
likely to
change very little
in 2007.
So what was a big plus for corporate profits in the
four years following the 2001 recession has shifted into neutral.

And then there is
international trade
… imports into the United States were

$2.0 trillion in
2005, or a record 16.2% of GDP. Exports totaled $1.3 trillion in 2005, also a huge
number but only 65% of imports. The mammoth difference between the level of imports
and exports makes narrowing the trade deficit a very hard task.

Let’s

make the optimistic assumption that import growth slows quite a bit. Imports grew
13% in 2005 and 1
2
%
so far in 2006
. Let’s say they grow by 10% in 200
7

--

then imports
will total $2.
49

trillion
.

And let’s assume that exports maintain their current growth

rate
of 1
2
% per year. Then exports will grow to $1.6
5

trillion and the trade deficit will
only

widen by about $50 billion
in 2007.

The bottom line


Now let’s sum up the pieces. We think household saving could rise by about $
3
5 billion
next year. Busines
s investment will rise by $
10
0 billion, but residential investment will
fall by $1
15

billion, for a net
decline

of overall investment of $1
5

billion. Our guess is
the budget deficit
is roughly unchanged
, while the trade deficit widens by $50 billion. The
net result {in billions} is:
-
$
3
5


$
15



$50 =
-

$
100

billion.

In all honesty, we are not sure that all {or any!} of the assumptions sketched out above
for
2007
will prove accurate
.

But it does seem reasonable that
falling house prices
may cause
American
households to save more rather than less of their incomes. And
a fairly
aggressive
pullback in housing does seem to be underway. Maybe we are not optimistic
enough about business investment prospects, or maybe we are too pessimistic about trade
improvement
. But we believe our numbers are likely to be “in the ball park”. So the net
result


that U.S. corporate profits will be
almost 10%

below their current level in 2007
just doesn’t seem absurd.

What is clear is that an outcome even remotely close to
a 10
%
decline

in profits between
now and 2007 is wildly different than the current consensus of expectation of a
10
%
increase

in corporate profits
next year
. So we think it fair to expect a large number of
negative earning surprises over the next 18 months, espe
cially among companies that are
primarily dependent upon the U.S. market for their sales.

So enjoy the equity party in
America while it lasts ... next year could look and feel very different.