What will happen to US corporate profits once the economy is forced to let go of the government’s helping hand?
That’s the subject of a new note from Credit Suisse, and the answer is predictably discouraging.
We’re now in the tenth quarter of the current profits expansion, with the profit share of national income nearing the highs of 2007.
Credit Suisse figure the trend can’t last much longer. Going back to 1949, the authors find that the average duration of profit expansions is 14 quarters. If this one follows suit, it would have just another year to go.
Could it prove to be surprisingly resilient? Unlikely, if history is any guide. As the authors write:
Three of the past dozen profit expansions have lasted much longer than the average of fourteen quarters. The cycle in the 1960s {32 quarters}, the one in the 1990s {31 quarters}, and the one in the most recent decade {20 quarters} are the stand-outs. The key to the longevity of these cycles appears to lie in either robust employment growth and/or robust private sector credit creation. …
Needless to say, neither robust employment growth nor private sector credit creation has been part of the profits expansion. Quite the opposite — both actually remain below levels from when it started more than two years ago.
Looking back to the previous profit expansion, which lasted from the third quarter of 2001 to the same quarter of 2006, Credit Suisse find that it peaked at a moment when private sector employee compensation was growing significantly faster than personal consumption expenditures. And the start of the current expansion was defined by expenditures once again outpacing compensation.
Yet without a further demand boost, Credit Suisse worry that incomes will once again grow faster than spending. That’s not necessarily such a terrible thing for the economy as a whole, but it’s a worrisome sign for profits.
And this is where the news gets worse. Back to Credit Suisse, who write:
To an uncomfortable extent, overall demand growth in this cycle has been dependent upon the Federal government issuing very large amounts of debt and then using the borrowed money to either cut tax payments or make direct cash payments to the US private sector or individual states.
In other words, demand has been a debt story, and while households have delevered in the last few years, the economy’s reliance on the government has grown.
But not only is the economy getting increasingly less demand bang per government buck, but also the number of annual bucks is likely to start shrinking soon. There is renewed fervour for deficit-cutting in Washington, and some of the tax breaks that emerged from last December’s tax cut compromise – specifically the deduction for capital investment and the 2 per cent payroll tax cut — only extend through the end of this year.
And no, we can’t rely on exports to make up for the demand gap. Roughly 30 per cent of S&P 500 revenue comes from outside the US, which Credit Suisse reason is too low a base from which to make up for the demand shortfall that would result from dramatic budget-cutting.
In other words, we’re headed for exactly the kind of fiscal consolidation that Ben Bernanke warned about in his speech Tuesday. And indeed, the process has already begun.
So be wary of consensus S&P 500 EPS, which have been hovering around $100 lately. Credit Suisse aren’t even comfortable with their own, less optimistic expectation of $95.
None of this, by the way, is a case against the US shrinking its annual budget deficits from the current 10 per cent of GDP (a debate for other posts), only an assessment of its potential impact on earnings. As Credit Suisse note, a breakdown in corporate profits “would not be the end of the world… But it would likely be the end of the cyclical bull market in US equities.”
A refreshingly philosophical attitude, though long equity investors might respond: “What’s the difference?”
Related links:
Bernanke: “The Economic Outlook” – FT Alphaville
US profit forecasts may be too rosy – WSJ