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No, Soaring Deficits Do Not Mean Record Corporate Profits: In Fact Just The Opposite

Tyler Durden's picture





 

Over the weekend there appears to have been more confusion about pretty much everything finance related by aspiring CTRL-V majors-cum-'market experts.' In this specific case, the correlation between the soaring US deficit is magically supposed to imply the causation of surging corporate profits. Standalone this would be wonderful, because in a socialist utopia thought experiment, where one could hit infinite deficits funded by some magic MMT money tree, corporation would make, well, an infinite amount of profits, and would be an incentive for the government to spend itself to oblivion. And everyone would be happy right: infinite corporate profits means at least some trickle down wealth, and infinity even minus a big number is still infinity, meaning full employment for everyone. Hence utopia. Idiocy of this conclusion aside, the bigger problem with making the biggest rookie mistake in finance (and statistics), namely confusing correlation with causation, is that it is, as usual, 100% wrong when presented with one counterfactual. And when it comes to counterfactuals of soaring deficits, one always goes to the place that has "been there and done all of that" before. Japan.

Why Japan? Because just like the US, Japan has seen its share of soaring budget deficits in both absolute terms and as a % of GDP. In fact, since the 1960s, the deficit as a % of GDP number has gone up, up, up.

So how have corporate profits performed in Japan during this period of "deficit spending into oblivion" utopia starting in 1960 and ending, well, never? After all recall that Japan will surpass one quadrillion in sovereign debt this year, and well over 200% in debt/GDP. Well, as a paper by Jim Montier (which we dissected previously) showed early this year, corporate profits in Japan have done poorly to say the least. Below is the Bloomberg data for the ratio for Japanese profits to sales for all industries.

In fact when plotting the two on the same chart and inverting the corporate profits axis, we get...

It should be clear to everyone, except for the most confused journalism majors, that if the correlation of soaring deficits did result in rising profits, than the trendline of the second chart above would be up. Not down. Alas, it is down.

And as the third chart shows, in Japan, over the past 40 years, soaring deficits have actually resulted in collapsing profit margins. Which incidentally, is how one refutes amateurish correlation=causation CPM click magnets.

But wait, there is more.

Because the question still stands: why did Japanese profits decline for over 40 years during a time when the Japanese government was spending like a drunken sailor. We explained it previously in detail, but here it is again in a nutshell:

  • in an environment of soaring liquidity and free money, the hurdle rate on new investments collapses, as does the requirement to invest in CapEx, both growth and maintenance. In fact, as we have shown over the past year, the age of the global asset base has hit a record high across the world, both in the developed and developing countries, leading to record low return on assets! (and record debt encumbrance, but that's a different story). On record old assets. And since companies are forced to dividend cash to shareholders at a record pace (in lieu of fixed income in a ZIRP environment), there is less and less cash left to support CapEx spending.

So why did cyclical (not secular) profitability in the US spike in the past several years? Two simple reasons: i) debt refinancings into an ever cheaper cost of capital, which however has now hit a floor as very little incremental balance sheet benefit is left for companies, both investment grade and high yield, and ii) SG&A reductions, as more and more companies lay off thousands, or merely replace their fixed cost structure with a cheaper employee base (converting from full-time to part-time workers is one example, and one we have documented extensively).

Finally, as we showed last quarter, corporate profitability has already peaked, and at in Q3 will post its second consecutive quarter of Y/Y declines. In the meantime, we believe it is unnecessary to demonstrate that US deficit spending did not decline at all in recent months, and in fact has at worst kept up at the same pace.

The key point is that it has been the Fed's easy money policies that have resulted in cyclical bouts of corporate profitability, whose end has usually coincided with the period of easy money. Now, however, the Fed has no choice but to keep ZIRP for ever, even as corporate profits have once again started declining, and there is no lever the Fed, or anyone, certainly not the US Treasury, can pull to push them higher.

In other words, an absolute dead end, and not to mention record deficits do not drive record profits, which was the original idiotic contention.

So instead corporates get a 2-3 year profit boost benefiting shareholders who get to cash out, while in return America has a record debt load to show for it. Sounds like a grand exchange... if only one lives in a socialist utopia, as taught by the Columbia school of journalism or comparable, and has no idea how every single instance of socialism ends when the other people's money runs out.

 


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Mon, 10/22/2012 - 14:44 | Link to Comment Skateboarder
Skateboarder's picture

We don't have a budget, remember?

Mon, 10/22/2012 - 14:54 | Link to Comment MillionDollarBonus_
MillionDollarBonus_'s picture

This article forgets that Japan has an export economy. America has a consumer economy, which is a completely different story. Government spending and low interest rates creates aggregate demand for consumer goods, which boosts the American consumer economy. Nobody can match the hearty American consumer - with record low interest rates fueld by safe-haven demand for our Treasuries and the dollar from all over the world, Americans are spending us into a new golden age. 

Mon, 10/22/2012 - 14:58 | Link to Comment rosethorn
rosethorn's picture

Actually, all it does is create more unpayable debt.  Barring default, some day all of the deficit spending and consumer loans must be repaid.

Mon, 10/22/2012 - 15:12 | Link to Comment ZerOhead
ZerOhead's picture

In MDBspeak "new golden age" = age where only gold has value.

Also don't worry about consumer loan repayment and deficits... they can easilt be repaid with even newer debt. Now don't ask any more questions and kindly pay the banker on the way out.

Mon, 10/22/2012 - 18:21 | Link to Comment asteroids
asteroids's picture

US take note. The Japanese are  spending themselves into oblivion. No growth, and no hope.

Mon, 10/22/2012 - 22:03 | Link to Comment jeff montanye
jeff montanye's picture

john hussman has a bit different take on the relationship between government deficits and corporate profits. 

 

"What remains then is a fairly simple assertion: the primary way to boost corporate profits to abnormally high - but unsustainable - levels is for the government and the household sector to both spend beyond their means at the same time.

If we go to the data, we see the link between profit margins and deficits in the quarterly figures, but the tightest relationship is actually a causal one - large government deficits (as a percentage of GDP) coupled with weak household savings rates result in temporarily high corporate profit margins, with a lead of about 4-6 quarters."

for more:  http://www.hussmanfunds.com/wmc/wmc120402.htm

 

Mon, 10/22/2012 - 14:59 | Link to Comment cifo
cifo's picture

I don't know what to believe anymore.

Mon, 10/22/2012 - 15:22 | Link to Comment falak pema
falak pema's picture

you sound like a girl who doesn't know whom she is going to take back to her room...I guess the economy feels the same way.

Mon, 10/22/2012 - 15:13 | Link to Comment yogibear
yogibear's picture

All the debt does is pull demand forward when consumers take out loans to buy overseas produced junk. As mentioned before it has to be paid back.

Debt saturation is a bitch.

 

 

Mon, 10/22/2012 - 15:51 | Link to Comment css1971
css1971's picture

Americans are spending us into a new golden age

Oh wow, good one. I found myself grinding my teeth when I read that. In fact I think I can feel my bloodpressure rising. If you made more of your posts Just a little more Krugmanesque you could have people bleeding from multiple orifices.

Mon, 10/22/2012 - 14:46 | Link to Comment Jason T
Jason T's picture

Thank you for this great analysis!

Mon, 10/22/2012 - 14:51 | Link to Comment Cult_of_Reason
Cult_of_Reason's picture

What, me worry? 

We will get iPad mini tomorrow and be rich. All AAPL investors have a God given right to get rich.

BTW, save a deer! Ban or move Deer Crossing signs and move Forward with Obama! Booyah!

Mon, 10/22/2012 - 14:51 | Link to Comment AcidRastaHead
Mon, 10/22/2012 - 14:54 | Link to Comment rosethorn
rosethorn's picture

Excellent analysis.  I would just add that with ZIRP in place, interest rates don't reflect the true risk of potential capital investment; creating a strong disincentive for investors to put cash into capital investments.

Mon, 10/22/2012 - 15:05 | Link to Comment duo
duo's picture

It's not just dividends.  Check out the semiconductor companies, and the billions of CASH they spend each year to buy their own stock back (most of which is options to top level employees and officers).  This cash could have been used to develop new processes or build plants, but no, we have the Taiwanese for that.  Meanwhile, the number of employees at these companies decreases every year as their revenue stays flat.

In fact, some of these executives are given bonuses on "revenue per employee".  Guess how easy it is to spike that number.

Mon, 10/22/2012 - 15:04 | Link to Comment DoChenRollingBearing
DoChenRollingBearing's picture

I do not have figures, but due to the very competitive automotive bearing replacement market in PERU, I would think that their margins are very low...  Toyota is feeling a lot pressure on the low end from Hyundai (in Peru), Hyundai sold more NEW CARS than mighty Toyota did in 2011.

The automotive and electronics industries are what made Japan mighty.  Both are slowing.  Automotive and electronics are slowing here in the USA.

***

If our deficits and economy model Japan's even somewhat closely, then YES, that would explain a large part of why US corporate margins and profits are down.  And will stay down.

EDIT:

Mish just put this piece up re Japan:

http://globaleconomicanalysis.blogspot.com/2012/10/seamless-easing-japan-falling-behind-in.html

Mon, 10/22/2012 - 14:56 | Link to Comment realtick
realtick's picture

Nothing like a good old-fashioned fued to inspire you guys to print great charts sans unnecessary arrows and bubbles.

Mon, 10/22/2012 - 15:01 | Link to Comment Widowmaker
Widowmaker's picture

Nothing assures record profits like bullshit, regardless if it is deficit spending or TARP or just mark-to-your-butthole accounting endorsed by uncle fascist himself. 

It's all the same racket.

This "market" is vapor, worldwide.  What's missing? 

PARTICIPANTS!

Mon, 10/22/2012 - 14:56 | Link to Comment Catullus
Catullus's picture

Because the Fed printing is financing the government cash deficit which is going to pay for welfare programs.

It'd be interesting to see where price inflation is occurring. Like where is the money trickling in. The college bubble is obvious. But I feel like those boomers, who will take SS but keep working, will just have another $1,200 a month to spend soon. Yeah yeah. Some people really need that and they're using it to make ends meet. They don't matter anyway. They never have. It's the upper middle class senior level manager with 30 years experience who hasn't saved enough to comfortably retire who's just going to get an extra grand a month to spend.

They got the massive bull market from 1980s-2000. The housing bubble. Their kids get student loan money. There have been a number of tax credits, interest deductions, stimulus payments along the way. Every time you think the baby boomers are spent, they land on Community Chest and find that marginal money laying around. Another debt financed (public debt) bubble is on the way.

Mon, 10/22/2012 - 15:24 | Link to Comment rosethorn
rosethorn's picture

Food and energy is where price inflation is taking place; funded by QE.  Take a look at Cost of Food near Exponential Trend...the CPI for food was relatively stable until the US dropped the gold standard. 

Mon, 10/22/2012 - 15:00 | Link to Comment Misean
Misean's picture

Seems you're saying that the initial recipients of freshly counterfeited funds...erm...generous gov't liquidity...benefit first, until the effects of a diluted monetary unit spread through the economy, thus revealing the true nature of the malinvested funds (that generated the initial illusory profits).

Seems the solution is to ramp the printing so that profits always outrun that whole diluted monetary unit thing...

Mon, 10/22/2012 - 15:08 | Link to Comment dark pools of soros
dark pools of soros's picture

it's not profits if it all goes into compensation bonuses..  at least that is what they'll tell the 'profit-sharing' sheep that there is nothing to share...

Mon, 10/22/2012 - 15:11 | Link to Comment falak pema
falak pema's picture

I suppose this post has been inspired by takes like this one : 

Fiscal Cliff: Connection Between Corporate Profits And Deficits - Business Insider

It would be nice if ZH comments this breakdown specifically. I may have missed something. 

Mon, 10/22/2012 - 15:45 | Link to Comment orangegeek
orangegeek's picture

"...Finally, as we showed last quarter, corporate profitability has already peaked, and at in Q3 will post its second consecutive quarter of Y/Y declines. In the meantime, we believe it is unnecessary to demonstrate that US deficit spending did not decline at all in recent months, and in fact has at worst kept up at the same pace. ..."

 

Bullish.  Time to go long. 

 

This planet is fucked.

Mon, 10/22/2012 - 15:51 | Link to Comment DosZap
DosZap's picture

We have other issues....................

The IMF as I am sure most are aware are proposing a Debt cancellation for ALL countries.Public debt canceled.

Rumor has it, if elected ObaMao is contemplating the exact thing.

In order to do this it means taking out all the Fed Bansters,including the Fed Reserve.

While I DO NOT ever see this happening, it would be a RESET,( a different kind of debt Jubilee) and your/our currencies worldwide, would be worthless overnight.

Enter NWO, and one currency.And likely WWIII.

Mon, 10/22/2012 - 15:51 | Link to Comment Tyler Durden
Tyler Durden's picture

Debt cancellation will absolutely never happen as it would wipe out the banker class equity tranche.

Don't forget: the IMF and the politicians work for the financial oligarchy. And always have.

The only way sovereign, and other debt, will be eliminated is by inflating it, which explicitly would benefit equities until input costs soar, at which point only hard assets will be lucrative (although at that point that word will have no meaning).

Mon, 10/22/2012 - 16:58 | Link to Comment crusty curmudgeon
crusty curmudgeon's picture

I don't understand how inflation is the ONLY way to eliminate debt.

First, much of the debt--including an ever expanding percentage--is long term debt.  As Gary North points out, hyperinflation is a relatively short-lived phenomenon and you can't continue it for decades as you would need to do to pay off the debt.

Second, why not default?  I would suggest that your language may be more accurately stated as:  "Debt cancellation will absolutely never happen IF (rather than "as") it would wipe out the banker class elite" (I changed this from "equity tranche" because I have no idea what that means--I hope my change is reasonably accurate).  Selective defaults, with the details leaked sufficently clearly and early to the banking elite, would allow debt cancellation without too much damage to the bankers.

Third, inflation itself could harm the bankers.  Banks are in business to loan money...fixed rate loan assets would be nearly worthless in hyperinflation.  While there are probably few fixed rate loans allowed in this environment, chances are low that you could keep up with rate adjustments.  The banks would fall behind, I would think.

Tue, 10/23/2012 - 05:33 | Link to Comment andrewp111
andrewp111's picture

Government debt cancellation absolutely can happen. The Federal Reserve buys up most of  the Treasury debt. Congress deletes those Treasury bonds from the balance sheets of the Treasury and from the Fed. The cash the Fed paid for the debt still exists on bank balance sheets, thus the debt has been "monetized".  This is no different than the government using pure seigniorage to cover its deficits. Is this inflationary? In a world of ZIRP and excessive private debt, maybe not. At least not right away. But if inflation does emerge later on, the Fed will have no way of draining the reserves from the system, as there will be no bonds to sell.

The BOE is openly talking about debt cancellation in the UK.

Mon, 10/22/2012 - 16:13 | Link to Comment Orly
Orly's picture

The lesson must be that once every ounce of profit has been pulled forward and the present expenses to sustain the status quo have been cut to the bone, eventually there is nothing forward to pull from unless the debt obligations for such a project get cheaper and cheaper.  Once ZIRP is enacted, the cost of future money can not be lowered any further, by definition of course, which would mean that there is literally nothing to pull forward any more.

Such short-sightedness is the bane of capitalism, where greed and near-term gratification can no longer sustain the economy in a robust manner and governments must enact policies that basically outlaw selling.  Sound familiar?

It seems that if corporate governance relied on the idea that a company should be built to last for the long-haul instead of having to satisfy shareholders in the immediate quarter, that would go a long way toward correcting the problems inherent in our current system.  Some balance must be struck between the correct and proper reporting of profits and the ability of investors to make money over time.

Getting rid of stock options as compensation for corporate executives would be the first step and is an idea that could be extrapolated to eliminating derivatives on a company's worth, i.e., the stock price, altogether.  In fact, one could argue along this line to eliminate options completely.  Futures contracts could be regulated such that only traders who have some business in that business could trade them.  ZIRP and QEtc. could no longer ramp the price of a barrel of oil to $138.

The circle would then reverse.  No more instant gratification, no more pulling forward, no longer a need for zero interest rate policies.  Mom and pop could feel comfortable once again in a buy-and-hold setting for their retirement.  Imagine a financial environment with no more bubbles.  All would be right with the world.

:D

Mon, 10/22/2012 - 16:33 | Link to Comment falak pema
falak pema's picture

you've just destroyed in one fell stroke the "quarterly report" mantra to service ONLY the supply side share holders that the Reaganomics mantra invented back in the 80s. How capitalism has morphed since the days a corporate was supposed to satisfy a) customer, b) its personnel and suppliers, c) its shareholders. It was a more long term and business cycle strategy game then; not a bubble cycle frenzy as today. 

Mon, 10/22/2012 - 16:47 | Link to Comment Orly
Orly's picture

And to think I am a firm believer in what has become labelled as "trickle-down" economics as proposed by Stockman and others.  Cut taxes, businesses hire more workers to pay taxes, etc., etc.

The ideas have been perverted and never properly implemented.  Same as so-called "Keynesianism."  That's not at all what Keynes said, debt into oblivion.  He said when times are good, save.  When times are bad, spend it and then some.

Both ideas have been hijacked by greedy, short-term thinkers and the manifestation of those ideas have been twisted so much as to be unrecognisable from what was their original intent.  The problem is that greed has pervaded our government such that the theory could be twisted for immediate gratification by legislation!

Always immediate gratification, whereas both ideas have great merit in economic theory.  Hell, Marxism would work- if it weren't for those meddling kids!

Tue, 10/23/2012 - 03:56 | Link to Comment nastaking
nastaking's picture

When Samsung launched its popular Ainol Novo 7 Crystal Android 4.1 in Australia back in May

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