Submitted by Rob
Corporate Profits Squeeze For Large Caps
US global large cap companies have enjoyed sustained above average profitability in recent years. There is an argument that this won’t be sustained and that profits will mean revert. The excess profitability likely has two causes: higher quality companies in the S&P, global labour arbitrage. The equity bulls generally believe that profits won’t mean revert and also usually point to a lot of S&P profits being earned in EM or similar as to why a reversion in US profitability wont detract as much.
I believe the global labour arbitrage at a minimum can not be sustained for much longer, while the quality of earnings aspect, at a minimum, is still cyclically vulnerable. Many of the bulls argue that these companies are ‘cheap’ or ‘cheap versus bonds’. I believe this is an area where many investors have ‘hidden out’ and there may be some complacency.
Global labour arbitrage (GLA/ outsourcing) background
I believe the conventional market view is that GLA increases profits by outsourcing lowering costs of production. In practice the opposite should happen to profits. As companies fire US staff to save costs, their revenues should fall by more than the cost saving; i.e. as the consumers lose their incomes and final demand falls; corporate revenue therefore falls and profit margins should be squeezed lower. This in turn should deflate the US economy until such time as exports and people employed in exporting take up the slack. However for terms of trade reasons, Asia has not wanted this to happen and the Fed/ US government fear deflation in a leveraged economy.
Therefore as Asian labour entered the global economy in the early 1990s the US government was happy to see the consequent wage deflation offset by the dot com productivity boom/ internet bubble. Coming into the ‘noughties’ without final demand being propped up the US should have deflated. However persistent US government deficits combined with a US private deficit (individuals borrowing money) inflated final demand, and this effect clearly shows up in growing corporate profitability in the 2004-2006 period. The effect of individual and Federal borrowing was sufficient to offset deflation and to inflate corporate profits consistent with a classical Austrian business cycle credit bubble. Coming into 2009 the US government then stepped in as the borrower of last resort and US consumers stopped their brief phase of deleveraging.
I argue that we are in a situation where a number of the factors prevailing now are likely to reverse, at least partially:
– Cheap Asian labour
– Fed deficit supported final demand
– Strong Asian demand
Cheap Asian labour:
Due to reflation many Asian countries are now running CA deficits. Even China has seen a loss of competitiveness, overall it would appear that the cheap Asian labour side of the equation is being eroded:
Fed deficit supported demand:
According to the Fed flow of funds data, as regarding borrowing that directly impacts final demand (government deficits and private individual borrowing), there has been no overall deleveraging:
(page 15 http://www.federalreserve.gov/releases/z1/Current/z1.pdf)
From the start of 2009 to end of 2011 US home mortgage debt has shrunk by $678bn. Although I don’t have the figures this probably accounted for by mortgage defaults. Consumer credit similar has hardly fallen. Meaning there has probably been little impact, yet, on final demand from any US private individual deleveraging.
At the government level, the combined Federal and state deficits seem to be stuck in a high single digit to GDP structural deficit range.
In summary, in recent history the Fed has continued to act as a borrower of last resort in propping up final demand, which in turn has artificially inflated/ sustained US large cap corporate profits from GLA. Anecdotal evidence suggests that SMEs which can’t really engage in GLA have not enjoyed such a strong recovery post-08.
EM/ Asian demand
Clearly many S&P companies have enjoyed strong operating performances in EM countries; however their businesses here and margins would not be immune from slowdown / EM FX devaluation.
US economic indicators have been weak and the following equity market indicators have been basically negative:
1. Volume – very low in August
2. Equity de-allocation, in part driven by baby boomer demographics and also regulation
3. Parcel company stocks have performed weakly through July/ August:
4. Weak US data/ earnings expectations by sell side analysts (I refer to the Albert Edwards note last week for more details)
5. Using Case Shiller (CAPE, http://www.econ.yale.edu/~shiller/data.htm), the S&P P/E is not cheap by historical standards and periods of economic turbulence call for below average valuations.
I would argue that US large cap corp profitability has been enhanced instead of eroded by outsourcing simply due to final demand being reflated by credit growth. That the US consumer’s deleveraging has not yet actually been felt in terms of final demand being squeezed and that the Federal government is going to go from supporting demand to detracting with some degree of fiscal cliff effect going into next year.
In a highly leveraged economy where SMEs are not performing well as evidenced by numerous anecdotal pieces of information and the overall weak post-08 recovery, the US could easily slide into a structural type deflationary recession. This is likely to have negative ramifications in EM/ EM FX where many of these companies have also enjoyed strong performance and negative implications for commodities and commodity exporters.
Technically, from anecdotal evidence, I believe that many investors have deallocated from areas like EM, cyclicals, small and mid caps and have ‘hidden out’ in what they consider to be high quality, global, large caps, which in their view are cheap and have a strong, defensive earnings outlook. This accounts IMO for a lot of the S&P outperformance of other major equity markets in the last year or two and the arguable premium valuation that the S&P currently enjoys over many other equity markets.
This note argues that many of the underpinnings of the above average profitability are being eroded and that over a period of time the margin level should fall or at least normalise to historical levels.
As this dynamic becomes apparent this should offer large down and then upwards tradeable moves in the S&P and correlated equity markets but that ultimately a derating will occur. It may be possible to trade via low delta put options.
Catalysts would be a cyclical downturn in the US economy coming into year end, a general risk-off phase or ‘surprisingly’ weak earnings in Q3 or Q4