End of the Profits Super-Cycle
The current profits recession may well be a short-term phenomenon. In due time, oil producers will remove supply from the market, inventories will fall, prices will rebound, and margins will return to normal. In the meantime, however, oil prices could fall even further if inventory capacity runs out, particularly as export sanctions on Iran have now been lifted.
When the commodity cycle inevitably concludes, to what secular rate of growth will market EPS revert? The real secular rate of growth in market EPS is far more important for long-term wealth accumulation than the duration of today’s cyclical fluctuation in profits. We have strong reason to believe that this secular trend growth rate in EPS will be much slower than many investors have come to believe is normal. To our long-time readers, this view should come as no surprise. In early 2014, we wrote about this subject in “The Profits Bubble”:
For nearly a quarter-century, we have experienced profits growing at a faster clip than GDP. Extrapolating this trend into the future is speculative at best. Equilibrium real growth in earnings per share cannot exceed real growth in per capita GDP, real growth in wages, and real productivity growth, on a long-term basis, without violating our sense of social fairness: More rapid growth in profits than GDP means a rising share of income to capital. Capital’s share cannot rise in perpetuity; social and political forces, if not economic developments, will cause it—sooner or later—to revert to a more usual level…
The macroeconomic cause of today’s profits bubble can be understood as a quarter-century of politically facilitated globalization. During the 50 years following WWII, we lived in an open global developed economy containing less than one billion people in Europe, North America, Australia, Japan, Korea, Taiwan, and a handful of others. Some countries were growing faster, some slower, but the technological level and population growth rates were not very different across the predominant countries within this relatively open global economy. The shares of income to labor and capital varied cyclically but tended to revert toward long-term averages.
Beginning in the 1990s, we experienced a seismic shift in our global political economy. Approximately three billion people began to join this open global economy: about one billion each in China and India and another billion or so in Russia, Eastern Europe, South America, and Southeast Asia. Average wages, level of technology, and amount of accumulated capital in the countries of the aspiring three billion lagged far behind those enjoyed by the one billion in the developed world. Imitation and appropriation is far easier than innovation and invention, so catching up has been rapid for those nations willing to make even modest concessions to the aspirations of their citizenry. For the past quarter-century, the capital and technology accumulated by the old equilibrium advanced global economy has been suddenly shared across a labor force and populace that quadrupled.
This tectonic shift in our global political economy produced some winners and some losers. Incomes of many of the three billion newly joined rose quickly. Global poverty rates have plummeted. Meanwhile, wages in the old advanced economy countries stalled at least partly in response to competition from the lower wages welcomed by workers in developing countries….
This period of globalization and the inflation of our profits bubble has been facilitated in part by a corporate capture of government policy, inhibiting competition, depressing investment, and promoting rent seeking. Rent seeking may be more extreme within our very own financial industry than in any other. TARP and QE are just the most recent and largest examples of government intervention to benefit corporate interests. For several decades, under governments led by both parties, the close nexus between Wall Street and Washington has facilitated an economic policy that favors politically savvy corporations and too-big-to-fail megabanks. Our policymakers have too often mistaken what is in the best interest of their elite peer group (and, surely by sheer coincidence, some of their largest campaign contributors) as in the best interest of the broader society. The result has been decades of stagnation in wages, high taxes on labor income, subsidies for debt and consumption, underinvestment, and soaring corporate profits.
Now, we applaud business success and the resulting profits, particularly when profits flow from inventing new processes, products, and services and providing value to customers. We eschew government meddling in the economy especially when the results favor the politically connected and thwart fair competition. Because globalization and corporatist economic policies seem to have unfairly tilted the scales against lower-skilled workers in developed countries, we sympathize with the growing political pressure to subsidize the creation of low-skill jobs, to improve the skills and wages of the less proficient, and provide a living wage to the working poor.
We cannot predict the quarter or year when profits will peak. We can predict the catalyst. The share of corporate profits is a political choice. The present share of income going to capital seems increasingly intolerable. Populism is rising throughout the developed world and will likely lead to political change. Today we have libertarians joining progressives in rhetorically attacking big banks and advocating redistribution through raising the minimum wage and subsidizing low-wage jobs. Expect corporations’ labor, interest, and tax expenses to rise faster than sales over the next couple of decades, and profits to grow much more slowly, or even decline, in real terms.
1. As of January 21, 2016, Standard and Poor’s estimates that for the 2015 calendar year reported EPS will decline by 7.3% and operating EPS will decline by 5.6%.
2. Reported earnings, which conform to generally accepted accounting principles (GAAP), are also known as GAAP earnings.