A Looming Profit Collapse?

This BBG headline “Corporate Guidance Is Now More Bitter Than Sweet: Taking Stock” caught my attention. The article notes that Q4 corporate profit guidance have started to lag analysts.  That is consistent with my expectations of a forthcoming string of negative profit surprises, let me explain why.

We have gone through unprecedented expansion and now contraction of the fiscal impulse. This chart from the Brookings institution, shows a measure of the fiscal impulse: the FIM (fiscal impact measure). It is based on a methodology developed by the Fed that measures the impact of tax and spending measures in the budget on private consumption and investment, as well as the direct impact of government spending on goods and services. As you can see the fiscal response to the pandemic has consisted of extreme expansions and contractions. Right now, we are in the contraction phase, a deeper contraction than even after the GFC. Basically, the budget deficit is contracting from 13% of GDP in FY2021 to 5% in FY2022, never seen before.

The question is who benefitted from the fiscal expansion? If you look at the share of profits in national income it is clear that businesses benefitted more than households. the share of profits went up and the share of wages went down, see Chart 1 below.  This is extraordinary because profits are residual i.e. what is left after suppliers, creditors and workers have been paid.  So, in a recession typically the share of profits goes down, that of wages goes up, exactly the opposite of what happened this time around.

This begs the question of what is different this time around. I think 2 things. First, in a typical recession, hours worked falls because firms keep more workers than they need to and cut their hours instead (see Chart 2 below). Why? Because hiring workers is costly, and employers typically expect the recession to end reasonably soon. But this time around as you can see from Chart 2 hours worked actually rose i.e. firms kept as few workers as possible and instead increased the hours of those who did not get fired.  This explains in part why firms are now scrambling to find workers, much more so than after the typical recession.

The second reason why profits have been so high is the unprecedented degree of concentration of the US economy, well documented in academic work including here. Large businesses’ market power is strong and stronger than workers’ bargaining power.  So, the purchasing power injected in the economy by the Biden administration’s enormous “rescue” plan benefitted businesses much more than households.

You can see that with, for instance, corporate profits reflecting more higher margins, that are at a historical high, than sales volumes see Chart 2. You can also see it with nominal wages barely keeping up with inflation (actually rising below inflation if you strip out compositional effects) see Chart 3. By the way, the idea that fiscal policy benefits profits more than wages was a contention of Polish/UK economist Kaletcki, a Keynes contemporary.  You can find a good exposition of Kalecki’s views  by GMO’s James Montier here.

If my views on profits are correct, we are likely to see a string of negative profit surprises  as the fiscal contraction works its way through the economy.  For instance, lower pandemic benefits mean a decline in household income and reduced pricing power for businesses.  The above BBG article suggests this is already happening and it is not good news for equities.

Dominique Dwor-Frecaut is a macro strategist based in Southern California. She has worked on EM and DMs at hedge funds, on the sell side, the NY Fed , the IMF and the World Bank. She publishes the blog Macro Sis that discusses the drivers of macro returns.

(The commentary contained in the above article does not constitute an offer or a solicitation, or a recommendation to implement or liquidate an investment or to carry out any other transaction. It should not be used as a basis for any investment decision or other decision. Any investment decision should be based on appropriate professional advice specific to your needs.)