The Fiscal Cliff and Corporate Margin Mean Reversion

As I wrote yesterday, government deficits are the biggest driver of elevated corporate margins. This is significant in the US given the looming fiscal cliff and the already ongoing margin mean reversion. Using the financial sectoral balances approach, it is clear that larger government deficits allow for larger non-government surplus.

The question is how those surpluses are distributed amongst the four major non-governmental sectors which are households, non-financial business, financial institutions and the external sector. Because the US is a large continental economy and the government ‘trades’ mostly with domestic economic agents, large changes in the trade balance are not part and parcel of net government dissaving. Rather, the net surpluses are mostly split amongst domestic businesses and households. And in this particular upturn, it has been non-financial business and financial institutions that have received the lion’s share of benefit from increased government deficit spending.

Nevertheless, as the Bloomberg News article below states, US margins have now stagnated for the longest period in the last three years, with S&P 500 companies seeing the first 12-month contraction since 2009. This makes sense because margins have been above their long-term average for quite some time now. The question about mean reversion of these margin has to do with a catalyst. From a micro perspective, the catalyst has been a lack of low-hanging fruit for cost-cutting to prop up margins. Having cycled through this upturn a full three years, cost pressures have risen.

From a macro, perspective, the fiscal cliff is an event of much greater importance. If deficits have been propping up corporate profits and margins. It stands to reason that cutting these deficits should be negative for profits and margins. Moreover, the S&P 500 has been trading above its cyclically adjusted P/E ratio for some time, a reason I felt earlier this year that a Europe over America relative value play made sense. But, this high CAPE is also mean-reverting, meaning that a large enough decline in deficits would potentially create the double whammy that causes bear markets, namely profit or margin decline combined with P/E ratio compression. A recession in 2013 is my base case and so I would anticipate this recession to usher in a cyclical bear market that finishes off the bottoming process that was forestalled in 2009.

If I am wrong and we can avoid recession, there is a reasonable chance that P/E margins alone could counteract margin compression. Moreover, if the fall in government deficits can be matched by an increase in capital investment, profits could be maintained (ceteris paribus). However, to date the problem in the US has been the lack of demand due to levered household balance sheets. Because of Fed policy, you can see residential property at a minimum picking up though. But, my sense is that austerity will kill demand growth and therefore cause capital investment growth to weaken. For there to be an investment offset, we would need demand not to recede. And so I believe austerity would see government sucking demand out of the economy and lower capital investment further sucking demand out, amplifying the downturn. Let’s look for clues as to where this is heading in the data that comes up going forward.


Analysis: Fiscal cliff could hit economy harder than many expect | Reuters 

“Like Capital Economics and many other research units in the financial world, Bank of America presumes every dollar of tightening would drain the economy by about the same amount, although it says a bigger effect is possible.

“The economic impacts could be worse than our baseline assumptions,” said Michael Hanson, an economist with the bank in New York.

Eichengreen and others who have studied economic data from the Great Depression, another time central banks were constrained, found the drag from a tightening of fiscal policy was much higher at the time. Eichengreen thinks currently the so-called multiplier is about 1.7, in line with the upper range of the IMF’s estimate.”

Charlie Rose Talks to Jeremy Grantham – Businessweek    

U.S. Margins Stagnate for Longest Stretch in Three Years – Bloomberg

“Chief executive officers in America are finding fewer costs to cut, sending profit margins into the first 12-month contraction since 2009 and leaving investors increasingly dependent on economic growth to boost stocks.”



Apple forecast to sell 102M iPads, 194M iPhones in 2013

“With 100 million iPads sold in its first two and a half years, Apple is predicted to sell another 100 million in just one 12-month span thanks in part to the addition of the iPad mini.”

Google Defends Leaving LTE Out Of The Nexus 4: None Of Its Excuses Are Good Enough | TechCrunch

“Google announced a host of new hardware today, including a new Nexus reference device for its Android mobile OS, the LG-manufactured Nexus 4. Reading through the Nexus 4′s spec list is like checking boxes on a list of what’s required for a smartphone to be competitive. Until you hit its wireless connectivity standards and find that LTE is missing, with only HSPA+ speeds supported. What’s going on? Google has a few answers, but none really grant the decision a pass.”

Apple’s Tim Cook shows ruthless streak in firing maps and retail executives | Technology |

“Apple was in crisis on Monday as it revealed that the architect of its iPhone software, Scott Forstall, once tipped as a future chief executive, is leaving the company next year. John Browett, the retail chief poached from British chain Dixons only six months ago, is also going.”   


Scott Forstall’s refusal to sign iOS Maps apology letter contributed to departure, sources say


“According to numerous reports from inside sources, Apple’s departing iOS chief Scott Forstall refused to sign an apology letter regarding the shortcomings of iOS Maps, possibly contributing to the executive’s ousting.”

With $15M from Andreessen Horowitz, ItsOn wants to arm operators with options — Tech News and Analysis

“distributed cloud-based platform that augments existing cellular networks, allowing operators to offer a wide array of flexible service plans for consumers that can be tailored to a user, sponsored through partners or subsidized through an employer.”

Anonymous Is Going After Zynga For Mistreating Employees, It Has Leaked Confidential Documents And Games | TechCrunch

The Apple-Amazon Stock Price Conundrum –

“In Amazon’s case, the thesis is that the company is reinventing retail and has no real competition. Witness that Amazon has double-digit revenue growth in a market where Wal-Mart Stores (WMT) is poking along with some 5% to 7% sales growth per annum. The industry is already one of razor-thin margin—Wal-Mart’s operating income is about 5% of sales—so what does it matter if Amazon spends more in order to take share, says the Street.

Apple, on the other hand, is a hardware company, in most people’s eyes, prone to see declining margins over time. Pegged as it is to the fashions of the iPhone and iPad, Apple is forever prey to the whims of style.”

Official: LG Nexus 4 lands November 13th for $299 with wireless charging | 9to5Google

“LG said a GSM/HSPA+ compatible Nexus 4 will be sold unlocked on more than 200 carriers worldwide with 8GB and 16GB versions available to purchase from Google Play starting November 13 in the following countries:

US, UK, Canada, Germany, France, Spain and Australia. Offline availability in Europe, Central/South Americas, Asia, CIS and the Middle East will begin from the end of November.”

Why The Future Of Search May Look More Like Yahoo Than Google | TechCrunch

“When you search, you know what you want (or something close to it) and the search engine points you in the right direction. You don’t need to pre-install the results or pre-select the right app.

We’ve seen that Google, Bing, and Yahoo! have already made efforts to “appify” their results. When you search for “The Dark Knight,” they all load movie show times, searching for addresses brings up maps, cities get weather forecasts, and stock symbols get charts, not to mention news results, image results, video results, etc. But, they’re all trying to cover every scenario without the help of partners, which, as we learned from Yahoo!, is impossible in the long run.

The answer isn’t to do it all in-house, nor is it only to enlist a community of app developers. The answer is a combination of the two: a portal connecting us to the app most qualified to accomplish the given query.”

As Google And Amazon Fight Up, Apple Refuses To Fight Down | TechCrunch

“In realtime, this seemed straightforward: Apple was trying to explain why their tablets were better than those made by the competition. Standard practice, right? But something about it stuck in my head as weird for Apple — especially once the price was revealed.

In the tablet space, Apple is without question the dominant player. By even acknowledging the competition, it’s a form of validation. Put another way: you should always fight up, not down. But here, Apple appeared to be fighting down.

But after the second watching of the keynote, my interpretation is slightly different. It’s a subtle difference, but an important one. I believe Apple was simply explaining to everyone that they were not going to fight down.”

Amazon suit shows Google as public cloud threat — Cloud Computing News

“At just a few months old, Google Compute Engine is seen as a threat to public cloud leader Amazon Web Services. At least that appears to be what Amazon thinks given its lawsuit against a former exec who is joining Google.”



A Look at Case-Shiller, by Metro Area – Real Time Economics – WSJ

“The composite 20-city home price index, a key gauge of U.S. home prices, was up 0.9% in August from the previous month and increased 2% from a year earlier. Seventeen of the 20 cities posted annual increases in August. Atlanta, Chicago and New York notched annual declines. Seattle was the only city to post a monthly decrease compared to July.”

German Jobs Machine Falters For First Time in Three Years – Bloomberg

“The adjusted jobless rate rose from a two-decade low of 6.8 percent in August to a revised 6.9 percent in September and held there in October, the agency said.”

Spain retail sales decimated by VAT hike | Reuters

“Sales fell 10.9 percent year on year, Monday’s National Statistics Institute data showed, reflecting an economy struggling through its second recession in three years and plagued by chronically high unemployment.

The drop was the biggest in calendar-adjusted terms since current records began in January 2004, and marked the 27th monthly decline in a row.” 

UK consumer lending hits 4-year high – Telegraph

“Lending to UK consumers rose at the fastest pace in four and a half years in September and mortgage approvals hit a four-month high, according to official data.”

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