by Brian Pretti CFA, Contrary Investor. October 16, 2009
So, once again quarterly corporate profit reporting season is upon us. Always a cheerful time of year, no? I want to step back a bit and try to put into longer-term perspective the issue of corporations acting to maximize profits in the current cycle. Is it different this time? What are the consequences of corporate actions to maximize short-term profits and what should we be looking for to suggest to us we exist in anything but a theoretically “normal” (whatever that means) economic environment? We know short-term investor perceptions regarding the character of corporate profits at any time is a very powerful driver of behavior and asset price movement. Once again, this week clearly proved this out. In the first and second quarter of this year, it was all about “less bad” that drove investor actions. As we move forward, it’s an absolute guarantee that investors and the financial markets as a whole will need to transition from the idea of “less bad” to actually assessing the reality of sequential quarter over quarter progress. But when? I’ve been suggesting quite loudly for some time now that companies that can show unit volume and/or revenue growth, or ideally both, will be focal points of attraction.
Very quickly, before jumping right in, net private sector debt contraction in the current environment is a major issue (at least in my minds). Major. I’ve talked about households that are perhaps in the midst of a secular change in attitudes toward consumption. I’ve talked about the clear and present need for household balance sheet reconciliation that is not about to be denied, evidenced by the fact that at generationally low interest rates, the year over year rate of change in consumer borrowing rests in negative territory. I’ve voiced my belief that monetary policy is largely impotent so far in terms of being able to spark credit cycle reacceleration, doing more harm than good in terms of unintended consequences. All happy thoughts, right? In looking at the issue of corporations that will certainly be acting to maximize short term reported profits ahead, as they have been incented to do really for decades now, let’s try to tie back into some of the issues highlighted above and try to focus on bigger picture perspective, leaving us all with questions hopefully important to financial market and economic outcomes ahead. All part of the process of benchmarking current cycle dynamics against prior cycle character. Enough, let’s get to it.
The first stop is a little peek at the very long-term cyclical nature of corporate profits in the US. Below we’re looking at the year over year change in after tax US corporate profits, inclusive of both the financial and non-financial sector. Important in that during the current cycle it has been the blow up in financial sector profits that has created the most hurt from a macro standpoint.
And what do we see? Well, despite all of the thoughts earlier this year that the US and possibly the global economy were headed into depression full speed ahead, the up until now cyclical decline in US corporate profits has been completely in line with rate of change bottoms seen over the last six decades in the US. Out of the ordinary in terms of cyclical earnings declines? It sure does not appear so when looking at these headline numbers without any further context. And one of the main reasons for this, as you know full well, is that US corporations have acted to reconcile costs in a major way, as any executive incented to preserve their reported earnings and stock price would do. Let’s face it, since August of last year the US has experienced a 5.8 million loss in jobs. Corporate earnings results may not have looked depression-ish in nature so far, but corporations have acted to reconcile their labor costs as if depression were a certainty. And you know from the recent CFO, CEO and the ongoing comments about the monthly small business NFIB survey, that none of these folks expect hiring to pick up meaningfully any time soon.
Again, is this some massive change from prior cycle experience in terms of labor and wage growth weakness of the moment? Of course not. It just so happens that in the aftermath of recent recessions past, corporations have been able to spark renewed profit growth by focusing intently on productivity. And this especially applies to the whole idea of “jobless recovery” periods. You know full well that the post 2001 and post 1990 recession periods were characterized as jobless in nature. The following combo chart shows us 15 quarters of post official recession year over year change in productivity and unit labor costs for each cycle.
You can see exactly the issue here in terms of the rhythm corporations will absolutely attempt to replicate in our present circumstances. After all, this is what they have “learned” in prior cycles. Really in the first two years out of the blocks post these two recessions documented above, year over year productivity gains exploded. And during these first two-year periods, the growth in unit labor costs ranged from subdued to almost non-existent. Exactly what we expect corporations to strive for as we look into 2010 and 2011. This is the proverbial playbook. In fact, this is exactly what is playing out right now. In deference to the transition suggested above that investors need to make in terms of looking at sequential quarterly progress as we move forward, the chart below tracks recent quarter over quarter change in headline productivity and unit labor costs. See what I mean in terms of the productivity and corporate profit growth playbook proceeding on schedule? Of course you do. The loser? Unit labor costs - employees. Profit growth with no employment gains - the theme of 3Q earnings reports we are now seeing? Absolutely.
Theoretically, corporate profits can thrive in a period of high productivity that is primarily being driven by softness in unit labor costs (wages). It’s when unit labor costs start to rise that both productivity and the rate of change in corporate profits starts to fall. Below, is simply the post 2001 recession experience as an example of this productivity and earnings progression versus labor cost changes as economic cycles progress and ultimately mature.
Okay, sorry to have literally dragged you through the mud of prior cycle experience. Let’s get to the important issues of the here and now. First, as we rush headlong into the current earnings season, it will be very important to watch how the markets respond to both reported earnings and management commentary about what lies ahead. So far, it’s the same game as the first and second quarter – better than expected, the world is not coming to an end, and record profits from banks who are not showing us, nor will they, their CRE losses. The markets have moved a long way in the last eight months and have discounted more than a fair amount of macro economic and company specific earnings recovery. Will current reported period earnings “recovery”, per se, be enough to satisfy what investors have already discounted? Watching the behavior of the markets as the news is revealed will be a key tell as to character over the remainder of the year. We’ll just have to see how it all works out, but so far it’s more of the same that we experienced in 1Q and 2Q.
But one thing which does seem pretty darn certain is that corporations will continue to press the productivity button hard in the quarters ahead, all in the hopes of both maintaining and growing reported earnings. But here comes the issue of the moment as I see it and really the key point of this discussion (it only took five pages to get here, right?). Within the character of the current cycle, will it be that case that the harder corporations push for productivity (and hence earnings) growth, the more they will imperil the ability of households in terms of their continued and surely ongoing need to reconcile their balance sheets, save and consume? Will corporations essentially elongate a true economic recovery cycle with laser focus on short term productivity? I ask this because what is different in the current cycle so far is the non-response of consumers to monetary policy. Despite low interest rates, there is little to no borrowing at the household level. Despite big time wage pressures, households have acted to increase savings and pay down debt balances (some of this is also default, to be honest). Let’s look at a long time relationship between corporate profits and wages I have not updated in quite some time that highlights the question of whether a corporate push for productivity will be counterproductive longer term to both the reality of longer term earnings growth and headline economic recovery.
The chart below is very simple and details a very simple economic trade off. The top clip is after-tax corporate profits as a percentage of GDP. The bottom clip is US wages and salaries as a percentage of GDP. The bottom line message being, what is good for corporate profits is not good for household wages, and vice versa. This is not some wild revelation, as you know.
Highlighted with red bars are the periods in which after-tax corporate profits as a percentage of GDP have been falling on a cyclical basis. Of course the mirror image of this is that these were also periods where wages and salaries as a percentage of GDP have been climbing. But as noted in the chart, really for the first time in six decades of recorded numbers, this tried and true relationship has hit a detour in the current cycle. At least since early 2007, both after-tax profits and wages and salaries as a percentage of GDP have been falling in concurrent fashion. And, without reaching for sensationalism, this truly is different this time. The numbers tell the story plainly. For now, the negatively correlated directional rhythm between these two data points has been broken. And that suggests some type of difference to the current cycle relative to prior half century experience.
And so as promised at the outset, here come the questions I hope are important as we move forward directly relating to the fact that corporations will act to keep productivity, and theoretically earnings, high in the quarters directly ahead in 2010 and 2011. The facts are that really for the first time in more than a half-century at least, we are experiencing net US private sector credit contraction. This credit contraction directly suggests monetary policy is not effective in the current cycle. Just how is net private sector credit to expand, or even stabilize (which would be a win in and of itself) when wages and salaries as a percentage of GDP are falling? How are wages and salaries to improve in a post recession environment that will theoretically be characterized as a “jobless recovery”? A recovery period where corporations will press for productivity improvement that can only come through the containment and rate of change suppression of unit labor costs. Monetary policy will only be effective from a longer-term standpoint if money is “borrowed” into existence by the private sector, and that’s not happening. The opposite is occurring. Bottom line being, do corporations do more damage to reconciliation of net private sector credit circumstances by focusing on short term productivity gains that will support short term “reported” earnings progress? It sure seems the answer is definitively yes within the context of an environment characterized by net private sector credit contraction. Contraction that really is a new phenomenon in modern US economic experience. In effect, corporations may be damaging their forward ability to earn in the domestic US economy by stretching for short term earnings gains in the quarters directly ahead at the further expense of labor. But, as always, it's all about the short term, right? What all of this is really suggesting is that we be open to the idea and thinking that the current cycle is indeed very different than what investors have come to accept as normal over the past half century. If we can "see" and document the divergence in the current relative to past cycles, it's only then that we can hope to navigate the waters ahead calmly and rationally, and of course hopefully successfully.
One last benchmarking view of life before. Below is documented the percentage gain trajectory in corporate earnings growth by quarter in post recession cycles stretching back four decades. Particularly of interest are the two “jobless recovery” periods of post 2001 and post 1990. In the aftermath of the post 2001 recession, corporate earnings followed a pattern not too far off what was seen in the cyclical recoveries of the 1970’s and 1980’s. A bit more subdued, but very similar directionally. Post 1990 was clearly the “quietest” of recoveries. You’ll remember that post 2001, the mortgage credit machine in the US was cranking up at full speed. In the eight quarters post the 1990/91 recession, total household debt grew by 10.3%. In the eight quarters following the 2001 recession, total household debt increased by 27%. Get the picture? Of course you do.
Question now being, what happens to corporate profit recovery in a net household debt contraction environment? As we see it, these themes highlighted are interrelated and very suggestive of key character differences in the current cycle relative to prior post war US economic cycles. As always, neither good nor bad, but rather and importantly just different. Flexibility and openness to change in thinking and analysis isn’t warranted at this point, it’s mandatory.
© 2009 Brian Pretti