The Great Macro Profit Illusion
The bulls have been bellowing about a superb run of corporate profits over the last few years. But is it really true? Dr. Richebächer picks through the numbers…
Is the U.S. economy stalling out, or is it resuming its strong growth, gaining traction for a self-sustaining expansion with healthy job and income growth?
In the consensus view, the economy’s weakness in the second quarter was nothing more than a "soft patch." We are no less sure that "traction" will remain elusive. It is the essential outgrowth of an upturn that has been of miserable quality right from the start.
With its advance estimate of GDP growth in the second quarter of 2004, the Commerce Department’s Bureau of Economic Analysis also released benchmark revisions to the national accounts data back to 2001. Notable adjustments include a markedly lower personal savings rate and a downward revision to economy-wide corporate profits for the past couple of years.
The biggest surprise in the GDP data was the reported sharp slowdown in consumer spending to just 1% at annual rate. But what about the other major demand components: business fixed investment, residential construction and inventories? Most important next to consumption is, of course, business fixed investment. In the consensus view, business investment spending continues to post healthy gains, thanks to exceptionally strong profit growth in the past two years. We have strong reservations about both the strength of investment spending and the exceptionally strong profit growth.
Consumer Spending Slowdown: 10% Fixed Investment Gain
Over the full year to the second quarter, nonresidential fixed investment rose by $108 billion, a remarkable rate of about 10%. That is, in fact, a healthy gain. But as already pointed out, the stellar aggregate number conceals an unusually lopsided investment pattern. The outstanding contributor is computer investment, thanks to hedonic pricing. Investment in industrial equipment, the key component for industrial production, was virtually stagnant over the year.
In addition, the accelerated depreciation allowance for capital investment spending that was part of the last tax package will expire at the end of this year. If businesses have pulled forward investment projects from 2005 into 2004 to qualify for the tax break, investment spending might slow sharply after the turn of the year.
Another highly popular argument of the bulls is the U.S. economy’s excellent profit performance in the past two years, as trumpeted by most Wall Street analysts. Here again, we must plead to keep things in perspective. Overall corporate profits peaked in 1997 and hit their low in the fourth quarter of 2001, virtually the end of the recession.
Our focus is always on the profits of the nonfinancial sector. At their high in 1997, they amounted to $504.5 billion. In the first quarter of 2000, just before the start of the economy’s downturn, they were down to $426.2 billion. At their low, in the fourth quarter of 2001, they amounted to $236.5 billion. In the first quarter of 2004, they had recovered to $420.7 billion.
From the low to the new high, they increased by 77%.
Given the simultaneous steep fall of share prices, this number certainly has a highly bullish flavor. On closer look, the steep rise was rather more bearish than bullish. First of all, the profit level of the first quarter of 2000 was manifestly nothing to crow about. It ushered in the economy’s downturn. Drawing this comparison, a further point to be taken into consideration is that today’s nominal GDP is up almost 20% since then. In 2000, those profits were equivalent to 4.4% of GDP. Presently, they are 3.6%.
Consumer Spending Slowdown: The Numbers That Matter Most
Bearing the structural distortions in the U.S. economy in mind, a most important aspect is the changes in profits between different sectors. They are, really, the numbers that matter most. For us, most striking, and also most telling, is the difference in the profit performance between manufacturing and retail trade. In 1998, manufacturing earned $157 billion, far more than retail trade, which earned $66.4 billion. But just six years later, in the first quarter of 2004, manufacturing profits were drastically down to $81.5 billion and retail profits sharply up to $80 billion.
There is a similar drastic divergence in profit performance within the manufacturing sector. Profits of the producers of consumer durables and capital goods have generally collapsed into persistent losses. In 1998, they earned a collective net profit of $83.4 billion, accounting for more than 50% of total manufacturing profits. By 2000, this had shrunk to $60 billion. But in 2003, a year of recovery, they ran a collective net loss of $3.5 billion.
It is most important to realize this extreme divergence in the U.S. economy’s profit performance because it is symptomatic of the marked, structural distortion that has been going on in the U.S. economy. Most remarkable, certainly, is the persistent savage profit deflation of the producers of high-tech equipment, unquestionably due to fierce competition. It is needless to say that persistent losses are prone to choke new investment.
Yet most conspicuous from a macro perspective is the flagrant diversion in the development of profits between manufacturing and retail trade. We looked back into the mid-1980s and noted that manufacturing profits were then about four times those of the retailers. Today, they are equal.
That is, of course, what has to be expected in an economy in which consumer borrowing and spending reign supreme.
for The Daily Reckoning
September 8, 2004
Oil was supposed to go up. Commodities, too. Gold, silver…all were on the way up.
Bonds and the dollar were supposed to go down.
All our friends believed it. We still do.
But not necessarily right away.
In our book, we saw the U.S. economy sinking into a slow, soft slump a la Japan. Of course, we mistrust all predictions…especially those we make ourselves. But so far…a slow, soft slump seems to be precisely the sump hole into which the United States is sinking.
Bonds have been in an uptrend since May. The dollar has held steady or improved slightly. Gold has gone nowhere. And commodities seem to be going down, not up.
And oil? It has backed off recent highs…and in real terms, oil is still very cheap compared to what it was a quarter of a century ago.
Has the world economy taken a new direction? Is it clear sailing from here to eternity?
Nope. And nope.
The prevailing winds are still blowing in the same direction…and they still lead to very rough seas. But it’s a big world. It can take a long time to get where you’re going.
What has not changed is that the amount of debt in the world is still increasing. In 1952, the ratio of domestic nonfinancial debt to GDP was only about 60%. Today, it is more than 160%. In the last three years, the U.S. economy has added $1.3 trillion to its GDP. But during that period, it also added $4.2 trillion in debt.
For the 36 years from 1952-1988, a dollar’s worth of GDP meant about an additional $1.50-1.80 in debt. But in the first three years of the 21st century, $3.19 worth of debt was added for every extra dollar of GDP.
Why so much more debt/GDP? Because more of the borrowing is used for consumption, rather than for production. When you take on debt, you can use it to build a business…or you can spend it. If you build a business, you employ people…build factories…buy capital equipment and so forth. This is the stuff that increases GDP – wages, profits, capital investments. But if you spend it – especially now, when so much of what we buy comes from Asia · the spent money boosts retails sales and then disappears. The resources that might have been used to increase wealth are squandered on trinkets, geegaws and calories.
But that is not the end of the story. When you borrow to build a business, you expect a source of earnings and profits that will make it possible to repay the loan. But when you borrow to consume…or borrow for a business that doesn’t work out…you can only pay back the money by spending less in the future. Sooner or later, you’re forced to cut back.
As the mass of debt increases, the debt itself begins to exert a gravitational pull on the financial markets. The whirling consumer bodies…the revolving loans…the Jupiters of mortgage finance…the Saturns, ringed with marginal borrowers – the entire solar system of debt gets pulled in tighter, as if toward a black hole.
In traders’ language, people are long inflation (betting that the money they have to pay back will be worth less than the money they borrowed)…and short the currency itself (the last thing they want is for the dollar to go up).
Mr. Market, in his typically perverse way, always tries to find a way to ruin the greatest number of investors. When people are short the dollar (as they are when they are deep in debt), he creates a "short squeeze" – people desperately need dollars in order to pay their dollar-denominated debts! Deflation, dear reader, deflation. Japan-style…slow, soft, sinking deflation.
Over the long run, though, the dollar can be expected to do what it ought. The denouement of this drama – when it comes· will be neither slow, nor soft, but violent and swift.
This from the forward of Pete Peterson’s book Running on Empty:
"America’s twin deficits are causing some of the world’s shrewdest financial minds to raise alarm. When two such experienced and understated executives as Bob Rubin, former secretary of Treasury, and Paul Volcker, former chairman of the Federal Reserve Board, join the many others who fear these twin deficits, I listen. Bob Rubin says we are confronting a day of serious reckoning. In referring to our fecklessness, Rubin warns that the traditional immunity of advanced countries like America to Third World-style crises isn’t a birthright. Volcker predicts we face a 75% chance of a crisis in five years.
"America’s twin deficits are now so large, and our savings rate so low, that there is a real danger that investors around the world simply lose faith in the dollar. According to Steve Roach, chief economist of Morgan Stanley, ‘It’s hard to conceive of a more unstable disequilibrium.’ For the first time in his 72 years, Warren Buffett, the Nebraska sage, is purchasing foreign currencies. Britain’s prominent fund manager and financial commentator Marshall Auerback says America has entered a banana republic-style debt trap."
Deflation will slowly squeeze American debtors. Then, when the debt trap suddenly springs shut, the dollar will do what banana republic currencies always d It will slip away.
More news, from the Baltimore HQ…
Tom Dyson, from historic Mount Vernon…
– On Sunday, your editor found himself at "Renaissance Fest" – a celebration of medieval culture on the outskirts of Baltimore. Boisterous mobs of surfs, peasants, wenches, barons, knights and court jesters plodded through the wood-chipped avenues, kicking up dust with their 16th-century heels. Thousands showed up, filling an enormous grassy field with shiny new SUVs.
– Jovial red-faced cider lovers packed the taverns. They wore patterned tights, medieval tunics, pantaloons and strange boots. And the women – old hags and comely maidens alike – wore elaborate corsets and flowing robes, now tatty from being dragged through the dust. Of course, not having made the effort to conform to the dress code, it was we who looked ridiculous.
– Like the fools at the festival, investors are clinging to an era that no longer exists. We’re not talking about swords and chain mail, but the unerring assumption that the status quo will be maintained. Nothing will happen. There may be dips and peaks along the way – and even long, festering periods of sideways meandering – but America’s long-term projection is assured.
– Nobody seemed to notice, but even the recession of 2001-2002 and the recovery of 2003-2004 were unlike those cycles in years gone by. "We’ve reached a major bottom," the lumps think. "Now it’s time to buy and hold again."
– But one man noticed.
– "It’s most important to realize that the U.S. economy’s slowdown over the past few years has nothing in common with the business cycles of the past," warns economist Dr. Kurt Richebächer. "Literally everything has been running contrary to the typical pattern of downturn and recovery."
– In the past, central banks hiked interest rates in response to heating inflation. They put the brakes on business and the consumer. We used to see a sharp decline in credit-financed expenditures like consumer durables and business fixed investment. This was the recession of a bygone age.
– But not in 2001, says Richebächer. The sudden nose dive in stocks and economic growth clearly had nothing to do with tight money or credit…the two were expanding in a fashion without historical precedent.
– "Fed Chairman Alan Greenspan and other policymakers like to boast that thanks to their policies, America had its mildest recession in the whole postwar period," writes the good doctor in his latest diagnosis. "This comparison is a deliberate delusion. To judge the success of the employed policies, it is, of course, also necessary to take the economy’s performance during the subsequent recovery into account."
– "As we have repeatedly stressed," continues Richebächer, "the 2001 recession and the following 2002-04 recovery years add up to the U.S. economy’s worst performance in the whole postwar period. But being forever flooded with optimistic comments and forecasts from cheerleaders Greenspan and Wall Street, very few people seem to be aware of this fact."
– Certainly not yesterday’s investors…they bought stocks. The Dow added 80 points, to 10,341, while tech investors pushed the Nasdaq up 14 points, for a 0.76% gain. The index closed at 1,859.
– And as for gold, well, the metal was once popular. But not any more. In the Middle Ages, the yellow metal was coveted, revered and worshipped. In the Information Age, it’s loathed. Now it sells for less than $400 again. Yesterday, gold declined $3, to $397.6. And the last time we looked, it was down again.
– But here at The Daily Reckoning, we don’t worry about daily price fluctuations. Instead, we sit and wait for something big to happen. It’s coming. We just don’t know when or how…
Bill Bonner, back in London…
*** The financial world is "on hold," as near as we can tell.
No one knows why. No one knows what will be said when someone finally picks up the phone.
But for the moment, everything is quiet.
"Nobody has any idea of what is going on," said our old friend John Mauldin, who stopped by for a visit over the weekend.
John is a Texas Republican with moderate views on most subjects. But we like him anyway; he brings BBQ sauce and chili peppers…and grills the steaks.
"Dubya is no fool," says John. "And if he gets another term – which I think he will – you’re going to see some changes.
"He’s basically got the right idea about things. But Karl Rove got ahold of him. And Karl only cares about winning the next election. After the election is over, I don’t know if Karl will have a horse in the next election or not…but it won’t be George W. Bush. So Bush will be free to do what he wants without worrying about re-election.
"He let spending get away from him during the first term…he was distracted by 9/11 and the war on terror…but it won’t get away in the second term."
Here at Daily Reckoning headquarters, we steer clear of politics. Money is our beat. But we can’t help notice that it is crowds of people that dominate markets as well as politics…and that group thinking leads them both, in similar ways, to do preposterous, absurd things.
"Group thinking" is, like "honest politicians," an oxymoron. Groups do not think. Instead, they desire. They fear. They panic. They go mad from time to time – sometimes believing they can get rich without working or saving…sometimes believing that they can all live at someone else’s expense…sometimes hoping that expensive stocks will become even more expensive…and sometimes just getting lathered up and setting off, hellbent on some self-destructive mania.
An individual knows he cannot spend his way to wealth. But put him in a group, and he’s ready to believe that "consumer spending" can make the whole society rich.
An individual knows he cannot kill another individual without risking jail…or hell. But put him in a crowd, and he’s ready to declare war on people he’s never met for reasons he’s never understood.
Groups – such as stock market investors – are dangerous, unthinking mobs…
*** In the British press, we find a couple of things worth mentioning. A study of single people – divorced, widowed or never married – found that living alone was a bigger health risk than smoking.
We’ve never understood why government was so insistent on trying to stop people from smoking. It is a "health risk," says the anti-tobacco crowd. But there are a lot of things people do that could shorten their lives. Why single out smoking?
"Smokers impose heavy costs on public health services," was the answer. But so do those who eat too much, do not exercise or never marry (at least, that is the implication of today’s headline article).
*** Elsewhere in the London newspapers, we find that English researchers working on skeletons in a Mexico City museum have concluded that the bones found in Baja California do not belong to the same race of "Native Americans" who are believed to have come over across the Bering Strait some 10,000 years ago. The bones in question have much longer, narrower skulls than those of the Siberian tribes that settled North and South America. These people – whom the British researchers believe came here from Southeast Asia or Australia – were apparently already in Baja California when the northerners arrived. The Baja bones have been carbon dated to 12,500 years old. DNA tests will be forthcoming. Stay tuned.
*** And back in France…
Two things are becoming popular according to today’s papers. First, the film The Choirboys was such a hit in France that it has set off a whole new mode for singing in choral groups. New groups are forming all over the country, with more than 300,000 people participating.
The other thing that has become fashionable in France is intentionally goofing off at work. A new book, Hello Laziness, tells how to do it.
Even The New York Times has commented on the new trend. Because the book’s author urged readers to work at "spreading gangrene through the system from within" by appearing to work but not really doing anything. This is a revolutionary doctrine, for the French typically do the opposite: They appear not to work too hard, while actually getting a lot accomplished.
What got the book widespread coverage was that the author’s employer, the national electricity company, found out about it and tried to fire her. Of course, this being France…even openly advocating internal sabotage was not enough to make a dismissal stick. She would have had to murder the CEO and the entire executive board…and even then she’d probably be back at work in a few weeks, with her employer forced to provide back pay as well as extra counseling!