The coming U.S. profits drought
James Saft is a Reuters columnist. The opinions expressed are his own.
HUNTSVILLE, Ala. – It’s not just that the U.S. economy is ebbing; the stock market has finally woken up to the harsh impact that government austerity will have on corporate profits.
Shares fell again on Wednesday, with the S&P 500 now nearly 15 percent below its late-July peaks. There are plenty of triggers for the fall — the downgrade of the U.S. by Standard & Poor’s and a worsening debt crisis in the euro zone
- but the truth is that the slow-motion small crash is best understood as a reading on what diminishing demand, caused by falling government spending, will do for profits.
Shares rose on Tuesday after the Federal Reserve nailed short-term interest rates to the floor for a promised two years, but that brief bout of euphoria quickly ebbed. It’s not surprising that the Pavlovian response to Fed stimulus is a rally, after all for the past 20 years every market crisis has been met by easier money. What is striking is that the half-life effectiveness of Fed action has diminished so greatly. Perhaps QE3, when it comes, will only buy the market four hours.
“Most investors think that dipping to fair value for a minute and bouncing is normal,” famed value investor Jeremy Grantham of GMO wrote in a note to clients.
“It is, in fact, highly aberrant historically. Markets staying down and washing away a whole generation’s false expectations, high animal spirits, and excessive risk-taking — that would be normal.”
Those resisting that “old normal” point to low share prices when compared to earnings. Sure, valuations are already low historically, but the screaming anomaly in the system is between the health and robustness of the economic system and the level of corporate profits.
Corporate profits before interest, depreciation and tax now account for about 35 percent of GDP, the highest such figure in at least 60 years. Those profits come courtesy, at least in the last couple of years, of deficit spending that helped take up the slack left when consumers realized they couldn’t get rich by borrowing against their houses. Profits have also benefited from efficiencies, of course, but that too ultimately has its limits.
The U.S. has offshored millions of jobs, raising margins, but in so doing has kept wages horribly stagnant. As Grantham points out, wages per hour in real terms in the U.S. are actually down over the past 40 years. Who will buy things, other than the top one percent? Can U.S. stocks prosper in a Versailles-style service economy aimed at only the wealthiest? Not likely.
Remember too that because wage growth has been suppressed in China by official policy aimed at maximizing exports, the consuming classes there are nowhere near large enough to take up the slack. Don’t believe those stories about Chinese driving Buicks and talking on iPhones. There are nowhere near enough of them to keep corporate profits in the U.S. where they are today.
If you accept that government spending in the U.S. will fall over time, you have to conclude that corporate profits will fall as well, at least for the time being. There could conceivably be some private market miracle of innovation and growth that eventually justifies higher stock market valuations, but that is neither guaranteed nor likely to arrive in the next couple of years.
In fact the only way, mathematically, that profits could be maintained at current levels or rise in the face of declining government spending would be for households to save less or borrow more. That isn’t happening; households are saving more than they did a few years ago, but less than they ought to given the poor performance of their assets and wages and the lousy state of their personal balance sheets.
Americans hold too much debt, have poor income growth and are in the process of losing faith in those two Easter bunnies of investment: housing and the stock market.
And remember, cuts in government spending are almost certainly what we will get. The Republicans on Wednesday announced their delegates to the Congressional “super committee” on debt reduction and all six are signatories to a “no new taxes pledge.”
So, the fall in the stock market is rational. There will be some mixture of falling corporate profits and slow to negative growth in the medium term, conditions that are good for safer bonds and bad for equities.
The main risk to this forecast is actually on the downside
- that a crisis in Europe or in the banking system prompts faster, more volatile falls.
The good news, but not for current equity investors, is that falling profits and rising wages will eventually be a harbinger of a recovering economy.
At the time of publication James Saft did not own any direct investments in securities mentioned in this article. He may be an owner indirectly as an investor in a fund.