No Record Profits For Old Assets: Jim Montier On Unsustainable Parabolic Margin Expansion For Dummies
It is widely known that US corporate profits recently hit an all time high. What is less known is that in Q4, profit margins for the first time rolled over by 27 bps, and double that if one excludes Apple. What is very much irrelevant, is that to Wall Street none of this matters, and the consensus (of which GMO's Jim Montier says "the Wall Street consensus has a pretty good record of being completely and utterly wrong") believes that Q4 will be largely ignored, and margins will continue soaring ever higher. Well, the same Montier, has a thing or two to say about this consensus surge in profits ("it is almost unthinkable that it will remain at current levels over the course of the next few years"). More importantly he looks at the Kalecki profits equation, and finds something rather peculiar. Namely Japan. Because while taking the profits equation at its face value would surely explain the 10.2% in corporate profits, of which a whopping 75% is thanks to America's burgeoning deficit, it would imply that Japanese corporate profitability, where there has been not only a long-running current account surplus, but zero household savings, and massive fiscal deficits, should be off the charts. Instead it is collapsing. Why? Montier has some ideas which may force Wall Street to renounce its bullish views, although probably won't. However, the implications of his conclusion are far more substantial, and if appreciated by corporate America (whose aging asset base is the problem), may ultimately result in a revitalization of the corporate asset base, however not before the dividend chasing frenzy pops in the latest and greatest bubble collapse.
First of all, for those who are not familiar with Kaleci, the Profits Equation, or any form of generic mumbo jumbo, here is the equation in question:
Profits = Investment – Household Savings – Government Savings – Foreign Savings + Dividends
How has this equation resulted in record profits? The chart below breaks out the various components:
Breaking this down historically yields the following chart:
So looking at historical and projected profit earnings, this is the consensus. Bear in mind this is critical for year end S&P targets above last year's closing level to make any sense without multiple expansion.
On the surface, this could be explained using the profits equation:
Let’s briefly examine the logic behind these drivers of profits. Investment (technically, investment net of depreciation) drives profits because when a firm or a household decides to invest in some real asset they are effectively buying the good from another firm, creating profits for that entity. Remember that this is aggregate; any single firm (even the world’s largest) is minuscule relative to the total amount of investment that occurs, so it isn’t possible for any given firm to bootstrap itself into profitability via investment.
Household savings are a drag on profits. This should be fairly obvious. Wages are paid by corporates to households, forming income from the household perspective. If some of this is saved, it is clearly not recycled into spending and, hence, is lost from the corporates’ year-by-year profits point of view.
Just like the household sector, government sector savings are a drag on profits. There are many transmission mechanisms between the government sector and the business sector, some reducing profits, some increasing profits. There is the tax route, whereby personal income tax reduces the amount of profits available to the business sector. Conversely, the government is also an employer, paying its employees who in turn spend and create profits. Plus, of course, there is direct interaction between the government sector and the business sector when the government is buying goods and services. All of these interactions (plus others) can be summarized into the government sector savings.
Foreign savings (also known as the current account balance) are also a drag on profits. Remember that the current account balance measures the amount that the U.S. owes to the rest of world (in terms of both actual goods and services purchased and investment flows) minus the amount that the rest of the world owes to the U.S. (again in terms of payments for goods and services and investment flows). If the U.S. is running a current account deficit, then it owes the rest of the world, and this is lost potential profits from the perspective of the domestic business sector.
Finally, we have dividends. This may seem like a counterintuitive source of profits since these are paid out by the business sector to households. However, from the perspective of the household sector, these are a form of income, which can be spent, thereby creating profits for the business sector.
This is all great. There is however one problem. Japan.
In Japan, we find a situation where the household sector is saving very little, there is a current account surplus, and the government is running a massive fiscal deficit. On these grounds, one would expect Japanese profit margins to be soaring. However, this
isn’t what we find. As Exhibit 7 shows, Japanese profit margins have been far below those seen in other nations.
What is the explanation for this dramatic outlier?
Given the massive tailwinds listed above, this can really only imply that net investment must have been massively negative - effectively, depreciation has outstripped any new investment. One can only ponder just how appalling Japanese profit margins would have been without all of the government help over the last two decades! Of course, if net investment were to turn positive (or even stop being quite so negative), then Japan could witness a marked improvement in margins.
And so once again we get back to what we have dubbed the primary cause of all of modern capitalism's problems: a dilapidated, aging, increasingly less cash flow generating asset base! Because absent massive Capital Expenditure reinvestment, the existing asset base has been amortized to the point of no return, and beyond. The problem is that as David Rosenberg pointed out earlier, companies are now forced to spend the bulk of their cash on dividend payouts, courtesy of ZIRP which has collapsed interest income. Which means far less cash left for SG&A, i.e., hiring workers, as temp workers is the best that the current "recovering" economy apparently can do. It also means far, far less cash for CapEx spending. Which ultimately means a plunging profit margin due to decrepit assets no longer performing at their peak levels, and in many cases far worse.
Furthermore, recall that in February we penned: '"No Continent For Young Assets" - Charting The Root Of Europe's Problems: Record Old Asset Age' in which we observed that the average age of European assets has hit a record high.
This also explains why banks have to dig progressively deeper into the sewer to pull out virtually anything that floats and hand it off to the ECB for collateralization, either in the open system or via repo. The reason is simple - there are not enough normal assets! And while we do not have the primary data, we are willing to wager that the average US asset's age is well on its way to record decrepitation.
The conclusion of all this is quite simple: the longer the "recovery" continues, without an actual recovery being coincident, and all is merely a game of optics and smoke and mirrors, corporate margins will start collapsing in a toxic spiral, whereby companies generate less cash, and have less cash to spend on CapEx, etc, until the next sector needing a Fed bailout is the corporate one, all the while the Fed's forced misallocation of resources forces companies to expend every available penny into dividend payouts.
Of course, this may well change. But if it does, and instead of pumping dividends, corporations do what they should be doing, which is begin the long overdue overhaul and update of their asset base, thing will eventually get back to normal, however record profit corporate margins will take a long time to return. And in the meantime, we sure would not want to be on the offer side of the collapsing dividend bubble...
Full Montier paper can be found here.