Opinion

James Saft

Stocks see fading help from QE, profits: James Saft

March 12, 2013

By James Saft

(Reuters) – Equity markets, especially in the U.S., are being held aloft by two historical anomalies – quantitative easing and high corporate profits – either of which could start to go away in 2013.

Friday’s surprisingly good update on the state of the U.S. job market raised the chances that soon the Federal Reserve will be more actively – and publicly – mulling how and when it will slow or end its purchases of assets.

At the same time, U.S. corporate profits are at vertiginous levels and climbing, arguing at the very least for caution about their future path.

That combination, of very good and growing corporate earnings and monetary policy which pushes investors to take risks in equities, has helped lift the Dow Jones Industrial Average to an all-time record.

What happens, however, if progress in the jobs market continues? That might reverse the wage suppression that has been a feature of the anemic recovery of the past few years, crimping profits, while giving the Fed reason to begin pulling its support for the economy.

If payrolls continue to grow at their improved pace, and if labor force participation doesn’t rebound, unemployment will have reached 6.5 percent, the Fed’s threshold for rolling back QE, by the summer of 2014. That is a lot earlier than markets are forecasting. Interest rate markets are discounting little or no tightening in real interest rates, meaning taking into account inflation, until 2018.

A quicker-than-expected normalization of monetary policy could be very destabilizing for markets; equities would suffer as support is removed and the knee-jerk rise in interest rates involved would undoubtedly catch out many who have loaded up on government bonds.

To be sure, it may well be that the Fed’s spotless track record of meeting financial market distress with easier money is itself underpinning markets. Who cares if the Fed is going to withdraw QE if they will only put it back on again when the Dow tumbles 500 points some fine Friday?

One reason to expect an early withdrawal of QE is the fact that it may soon be attacked on two fronts. A small but vocal minority of Fed officials, notably Richard Fisher of the Dallas Fed and Charles Plosser of the Philadelphia branch, worry about its unintended effects and effectiveness and are calling for bond purchases to be tapered. Then, if job growth is sustained, the QE doubters may well soon be joined by Fed officials from the middle ground, bringing forward the timetable for tapering or ending bond purchases.

PROFITS’ MAGIC CARPET RIDE

With this as a possibility, it is important to realize exactly how remarkable the growth of corporate profits in the U.S. has been, especially given the economic backdrop. Corporate profits after tax now account for about 11 percent of GDP, having oscillated between 4 and 6 percent between 1950 and 2000.

A simple return, over several years, to the historic mean implies really poor future returns for stocks in the absence of some other extraordinary support.

But why might profits drop? Firstly, profits have expanded in part because wages in the U.S. have taken a smaller and smaller piece of the pie; now below 44 percent of GDP and dropping, down several percent since 1999. That is in part the fruit of globalization and the offshoring of jobs. However, that which can be offshored largely has been and the likely trend is for new manufacturing technologies to start pushing jobs back into the U.S. As well, a rebound in housing markets is the kind of growth which can only happen onshore.

Secondly, there is the issue of the potential for declining government spending. A dollar spent by the government is a dollar that supports household income, and consumption, and corporate profits. Whatever the right policy should be, the debate now is about the extent to which government spending is curtailed, in real inflation-adjusted terms, over time.

When governments cut back on deficit spending, the only hope for profits is a cutback in household savings, which would run against both the trend and, given the pitiful state of Americans’ retirement accounts, logic.

“Here is the punch line. Any normalization in the sum of government and household savings is likely to be associated with a remarkably deep decline in corporate earnings,” John Hussman of the Hussman Funds wrote in a note to clients.

That decline in earnings is going to hurt stocks, especially if companies are caught in a vise between a rise in earnings and a gentle decline in revenue from government spending. If profits fall just as the Fed is withdrawing support, either because employment has recovered or because it has lost faith in its own magic – then watch out.

Equities’ best hope might be a cut in government spending deep enough to kill job growth – and extend QE.

That is neither likely nor desirable.

(James Saft is a Reuters columnist. The opinions expressed are his own)

(At the time of publication, Reuters columnist 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. For previous columns by James Saft, click on)

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