November 4th, 2012
in Op Ed
by Edward Harrison, Credit Writedowns
As I wrote yesterday, government deficits are the biggest driver of elevated corporate margins. This is significant in the US given the looming fiscal cliff and the already ongoing margin mean reversion. Using the financial sectoral balances approach, it is clear that larger government deficits allow for larger non-government surplus.
The question is how those surpluses are distributed amongst the four major non-governmental sectors which are households, non-financial business, financial institutions and the external sector. Because the US is a large continental economy and the government 'trades' mostly with domestic economic agents, large changes in the trade balance are not part and parcel of net government dissaving. Rather, the net surpluses are mostly split amongst domestic businesses and households. And in this particular upturn, it has been non-financial business and financial institutions that have received the lion's share of benefit from increased government deficit spending.
Follow up:Nevertheless, as the Bloomberg News article below states, US margins have now stagnated for the longest period in the last three years, with S&P 500 companies seeing the first 12-month contraction since 2009. This makes sense because margins have been above their long-term average for quite some time now. The question about mean reversion of these margin has to do with a catalyst. From a micro perspective, the catalyst has been a lack of low-hanging fruit for cost-cutting to prop up margins. Having cycled through this upturn a full three years, cost pressures have risen.
From a macro, perspective, the fiscal cliff is an event of much greater importance. If deficits have been propping up corporate profits and margins. It stands to reason that cutting these deficits should be negative for profits and margins. Moreover, the S&P 500 has been trading above its cyclically adjusted P/E ratio for some time, a reason I felt earlier this year that a Europe over America relative value play made sense. But, this high CAPE is also mean-reverting, meaning that a large enough decline in deficits would potentially create the double whammy that causes bear markets, namely profit or margin decline combined with P/E ratio compression. A recession in 2013 is my base case and so I would anticipate this recession to usher in a cyclical bear market that finishes off the bottoming process that was forestalled in 2009.
If I am wrong and we can avoid recession, there is a reasonable chance that P/E margins alone could counteract margin compression. Moreover, if the fall in government deficits can be matched by an increase in capital investment, profits could be maintained (ceteris paribus). However, to date the problem in the US has been the lack of demand due to levered household balance sheets. Because of Fed policy, you can see residential property at a minimum picking up though. But, my sense is that austerity will kill demand growth and therefore cause capital investment growth to weaken. For there to be an investment offset, we would need demand not to recede. And so I believe austerity would see government sucking demand out of the economy and lower capital investment further sucking demand out, amplifying the downturn. Let's look for clues as to where this is heading in the data that comes up going forward.
"Like Capital Economics and many other research units in the financial world, Bank of America presumes every dollar of tightening would drain the economy by about the same amount, although it says a bigger effect is possible.
"The economic impacts could be worse than our baseline assumptions," said Michael Hanson, an economist with the bank in New York.Eichengreen and others who have studied economic data from the Great Depression, another time central banks were constrained, found the drag from a tightening of fiscal policy was much higher at the time. Eichengreen thinks currently the so-called multiplier is about 1.7, in line with the upper range of the IMF's estimate."
"Chief executive officers in America are finding fewer costs to cut, sending profit margins into the first 12-month contraction since 2009 and leaving investors increasingly dependent on economic growth to boost stocks."
Read more by Edward Harrison
About the Author
Edward Harrison is the founder of Credit Writedowns and a former career diplomat, investment banker and technology executive with over twenty years of business experience. He is also a regular economic and financial commentator on BBC World News, CNBC Television, Business News Network, CBC, Fox Television and RT Television. He speaks six languages and reads another five, skills he uses to provide a more global perspective. Edward holds an MBA in Finance from Columbia University and a BA in Economics from Dartmouth College. Edward also writes a premium financial newsletter.