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.
[9]
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 [10]) 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.
[11]
In fact when plotting the two on the same chart and inverting the corporate profits axis, we get...
[12]
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 [10], 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 [13], 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 [14]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.