S&P 500 (SPX) Futures Contracts: Expect a Bear Market in Profit Margins


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Over the past 20+ years, the combination of large budget deficits and falling real interest rates has helped cause corporate profits to rise simultaneously and savings to decline across the world. ‘economy. While the national savings rate has been declining since the late 1990s, corporate profits have managed to reach record highs due to rising budget deficits and declining personal savings. It is highly likely that the current high corporate share of national savings will be reduced in the coming years as pandemic-era wage subsidies are removed and consumer savings rates increase. This has the potential to cause earnings to slump over the next few years, even as the economy continues to grow.

Profits are only part of national savings

Corporate profits are only one form of national savings, the others being personal savings and government savings, the inverse of the public deficit. It follows that the greater the amount of aggregate savings in the economy, the greater the amount of corporate profits. The graph below shows gross and net national savings and corporate profits relative to GDP since the 1940s. Profits and savings were closely related until the 1990s, as one would expect.

Gross savings, net savings and corporate profits, % of GDP

Graph, line graph, histogram Description automatically generated

Source: Bloomberg, Federal Reserve

Since the 1990s, however, the increase in corporate profits relative to GDP has actually been accompanied by a decline in the amount of overall gross and net savings. This appears to be the result of rising budget deficits and falling real interest rates over this period, which both undermined national savings relative to GDP and helped channel a growing share of them into company coffers.

How to think about national savings

The concept of savings can be quite difficult to understand, especially when the Federal Reserve prints money at will, creating the appearance of savings. The best way to think of national saving from an economic perspective is total production minus private and public consumption. After all, if goods have been produced and not consumed, regardless of relatively minor inventory movements, those goods must be investment goods; goods that can be used in the production of more goods and services in the future. Gross savings are currently 18% of GDP. To arrive at net national savings from gross national savings, one must remove the cost of consumption or depreciation of capital, which is about 16% of GDP currently according to the NIPA accounts. This means net saving currently stands at less than 2% of GDP, having fallen more than 13% at its peak in the 1960s.

U.S. Net National Savings, % of GDP

Source: Bloomberg, Federal Reserve

From a revenue perspective, the share of these net savings that ends up in corporate coffers reflects consumer behavior as well as government behavior. For a given level of wages and salaries, the more consumers spend on goods and services, the higher the level of profit. Meanwhile, for any given level of consumer savings relative to wages, the more the government spends relative to its tax revenue, the higher the level of profit.

How fiscal and monetary policy temporarily boosted profits and sank savings

As mentioned above, a country’s savings rate is the inverse of the share of personal and government consumption. While government consumption itself has not grown much in recent years, the rise in private consumption explains the decline in the US savings rate. The huge budget deficits observed over the past 20 years, and particularly over the past 18 months, together with falling real interest rates, have simultaneously undermined the overall level of savings relative to GDP and helped to sustain business profits.

Focusing first on the impact of fiscal policy, fiscal deficits support corporate earnings in two main ways. The first is directly linked to the decline in corporate tax revenues. In the late 1990s, corporate taxes accounted for more than 30% of pre-tax profits and 2.5% of GDP. Those numbers have since fallen to 12% and 1.6%, adding nearly a full percentage point to after-tax corporate profits.

Corporate taxes, % of profit before tax and % of GDP

Source: Bloomberg, BEA

The second path has been to increase transfer payments to households. This allowed consumers to increase consumption to a record share of GDP even as wages and salaries stagnated. At the aggregate level, the more consumers spend relative to the wages companies pay them, the higher the level of corporate profits. By supplementing incomes to such a degree, the government allowed consumers to spend what would otherwise have been beyond their means, indirectly subsidizing corporate profits.

Falling real interest rates were an additional factor that lowered aggregate savings rates while supporting corporate earnings. As interest rates were reduced, this acted as a direct reduction in the amount of business revenue paid to consumers in interest. All other things being equal, lower interest payments undermine personal income, which, for any given level of spending, translates into lower levels of personal savings and hence corporate profits. One might have expected low interest rates on savings to be offset by reduced consumer spending, but rising stock prices appear to have encouraged individuals to continue to reduce their savings rate. for corporate profits.

Implications for future earnings growth

This means that for businesses to continue claiming their current high share of national savings, the budget deficit will likely need to remain at record highs. If the budget deficit were to shrink as Covid-era transfer payments are scrapped, as is already starting to happen, consumers would have to continue spending beyond their earned income. Even a slight increase in precautionary savings would eat away at companies’ share of national savings.

It could be argued that any increase in the personal savings rate would allow an increase in the overall national savings rate, meaning that corporate profits would remain unchanged. For example, if consumers began to save more of their wages and reduce their spending on consumer goods, firms would simply turn to producing more capital goods, keeping profits high. The problem is that this accounting identity simplifies the difficulty of this transition. The transition to higher personal savings rates, especially if abrupt as in the Great Recession, tends to create an economic shock, as changing consumption patterns lead to a chain of income declines in the economy. entire production structure. This is why recessions tend to cause total savings to decline even as personal savings rates rise.

It is of course possible that amid the growing demand from politicians and millennials for modern monetary theory and a universal basic income, consumer spending will remain high relative to wages, allowing corporate profits to continue. to carve out the lion’s share of total savings. However, maintaining wage subsidies is very likely to put upward pressure on wages as the bargaining power of workers increases, which would increase the share of savings held by consumers while further weakening the national savings rate.

Even a slight decline in profit margin could lead to a significant drop in inventory

The following chart shows U.S. corporate after-tax profits as a percentage of GDP and as a percentage of gross savings since 1947 relative to their long-term average. Profits currently represent 12% of GDP and 64% of gross savings against a long-term average of 7% and 35%, respectively.

Source: Bloomberg, author’s calculations

If we see a return to long-term averages as I expect, and as has been the case throughout history, it would have a devastating impact on earnings. For example, even if mean reversion occurred gradually over a full decade, it would result in a 5-6% annual reduction in profit margins. Considering that real GDP and national savings are not expected to grow by more than 1% in the long run (see ‘1% US real GDP growth over the long term, an optimal scenario’), this would imply a 4-5% annual decline in real profits over the next decade.

It wouldn’t be as problematic for equities if the multiples were at reasonable levels, but that’s far from the case. Investors pay a near-record peak income of 26 times. If the P/E ratio were also to mean returning to its long-term average over the next decade, this would act as an additional 5% annual drag on the SPX, leading to annual real losses of 9-10%.


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