On Memorial Day this year, we lost our best friend, Godiva. This piece is dedicated to the wonderful memories she gave us.
It seems absurd to consider that 2013-2023 will be a decade of lost profits when they have grown explosively – +178% in the past decade. Surely the next decade would be better for corporate profits than the decade that saw the biggest recession since the Great Depression.
As the private sector recovers with a return of housing and automobiles, consensus analyst estimates put 2014 S&P 500 EPS over $123, more than $20 — and 20% — above the present value, representing a substantial re-acceleration of profit growth.
In order to judge the veracity of these estimates, we must first ask ourselves – why are corporate profits already so high?
A unique combination of factors led to this scenario. Technology boosted productivity, which allowed corporate output to be generated with lower labour intensity. Meanwhile, large deficits stabilized end-demand so the less productive workers displaced out of their jobs could still consume the output.
At the same time, there was an explosion of foreign profits, partially due to growing export demand, and the balance attributable to the foreign exchange rates gaining strength, so USD-denominated EPS increased as foreign-denominated sales were booked in USD.
The level of profits, along with the consumer price level, form the tug-of-war between labour and capital, and the Great Recession provided much slack in the labour market, allowing the balance to shift towards capitalists. The balance between labour and capital is probably most regulated through corporate taxes, which (like most taxes), are near all-time lows levels.
At their core, corporate profits are what’s left after a business has invested to create a productive asset, has sold the output of the asset, and paid the costs to maintain and operate it. The most important deduction is that revenue, hence profit, is limited by the productive capacity of a corporation. That productive capacity is build out through investment. Therefore future profits are governed by present investment. As per figure 5, high (low) re-investment has a strong relationship to high (low) future profit growth.
American corporations now have turned from investors to rentiers, and that’s not just bad for present-day employment: it’s also the ultimate limiting factor on future profit growth.
The profit level itself is well known to be anti-correlated with future profit growth. Fat profits themselves are a target for other corporations, both domestic and foreign. Combined with the declining labour, real capital and financial intensity of production, technology enables competition to chip away at high profit levels.
Foreign revenue seems unlikely to provide the same boost as it has before, along with the companion foreign exchange gains. With much of the emerging markets going through economic rebalancing growth pains associated with their rapid growth, and the Eurozone continuing to tread lower (unemployment continues to get worse despite the “solutions” implemented), this likely means at least tepid-at-best demand for American output internationally as the foreign cost of production adjusts downward.
If profit growth doesn’t manifest from trade, it must come from either the government deficits, or from the household sector. It seems unlikely that, absent a new recession, there is any political support from either party to increase the deficit. It already has been cut in half, now running at 4.89% of GDP, down 1.6% of GDP between 4Q and 1Q alone. Concurrently, after years of leveraging, the de-leveraging process in US households may be finished in aggregate, but the demand for credit remains nearly zero despite record low interest rates. It seems unlikely that these two factors will provide much support for corporate profits.
The weak labour market post-Great Recession that has provided a great boon to the corporate negotiations with the labour market will not last forever. The Japanese, despite decades of balance-recession, have seen unemployment rates drop through scarcity of prime-aged workers. This is not immune to cyclical effect, but over the long-term, the Japanese experience has seen their labour scarcity result in very low unemployment rates. The US experience may be different, but it is also rapidly converging on higher dependency ratios. Ceteris paribus, this will boost labour negotiating power over corporations.
Ultimately, future profit growth is predicated on realizing return on assets created through investment today. Corporate behavior has instead been a rush to claim economic rents rather than creating new assets. When or if the long-term growth outlook improves, investment to create new capacity will be more expensive due to fewer peak-aged workers. It is impossible to know exactly how the future will play out, but though it is unlikely that profits will actually decline (this has not happened since the 1950′s), the great tail-winds that drove it to the present levels probably won’t persist into the next decade. In fact, the most probably case is an unremarkable reversion to normal levels of profit/GDP with lower free-cashflow yields, lower unemployment and higher wage growth.
The ultimate question to most readers: how does it matter to asset prices? Using the assumption that all assets have the same risk-adjusted expected return (why would you hold an asset that has an inferior one?), we can compare the yields on stocks and investment-grade corporate bonds through the Levered Equity Risk Premium to infer what rate the market already expects equities to grow earnings. The present value of +0.78% indicates that the capital markets already discounted this. Until LERP breaches sub-zero, investors should expect to be able to capture a risk premium as long as EPS don’t fall.
However, if profit growth does remain tepid, investment grade corporate bonds are likely to at least beat equities on a risk-adjusted basis.
What does this all mean? My conclusion is that corporate profits are going to be weak over the next decade, but that it actually won’t matter very much to assets, and even be beneficial to labour.
Let me share two memories of Godiva.
My wife, Jillian, rescued her a year before she met me. The first time I met Godiva, it was the third date with Jillian, late at night after watching the Rochester Philharmonic Orchestra. As we went up the two flights of stairs in her parents house, Jillian first, the dog in the middle, and me trailing, Godiva stopped and turned around on the second last step, baring her teeth and growling. I don’t speak dog, but she was pretty articulate: you’re okay, but this is where my family sleeps, and you’re going no further. Jillian had actually wandered away into her bedroom, and I (not wanting facial rearrangement) had to call softly to her to intervene, trying not to startle the agitated beast in the process. She didn’t hear me over the air conditioning, but came back out a few moments later to see where I was. After seeing the situation, she dragged Godiva fully up the stairs, we all sat down, and the unfamiliar 90lb black dog hopped in my lap and gave me plenty of compensatory kisses. This was the rocky start to our relationship, but I learnt the most important thing about her character that night: her pack was the most important thing to her.
The second story was in the loudest thunderstorm I’ve ever witnessed. We took a while to fall asleep with all of the banging and crashing. Godiva, like many dogs, wasn’t a fan of thunderstorms. When the loudest thunder rattled the house, we all woke up, and the dog immediately rushed to close the gap between the door and her “mother”, barking and growling in a valiant attempt to intimidate the invaders. After she had successfully warded off the villainous thunder, she put her tail between her legs, and slinked up onto the bed (she rarely slept with us), balling tightly between us, obviously still very frightened. It was at that point that I knew her character was noble and indomitable. She was willing to face head-on something she greatly feared in order to protect her pack.
She waited for us to come home every night, and this is her face in the upper bedroom window of our old home. I hope there’s a dog heaven, I hope that’s where we go, and if there is, I’m pretty sure this is what we’ll see when we get there.