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United States Corporate Profits: Stronger 2009, Slower Improvement Ahead Global Bond Bubble Bursts - Benign or Malign? View GEF Archive

		The Global Economics Team

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But this adjustment changes the level more than the growth rate of future profits, and boosts earnings growth in 2009 at the expense of 2010.  Although the most intense profit declines are likely behind us, the near-term big picture remains grim: The US and many overseas economies are still contracting, non-financial profit margins are still under pressure and coming gains in financial earnings are likely to be more subdued.  Netting the headwinds and tailwinds, we now expect a 2% rise in NIPA earnings in 2010, compared with our 12.4% estimate last month.  This revision would still leave the peak-to-trough decline in earnings so measured at 33% between 3Q07 and 4Q09.  Like the recession itself, if realized, this decline would be the steepest in the post-war period.

Nonetheless, there are positives for earnings growth in 2010 and beyond.  Recovery at home and abroad should begin to lift top-line sales and margins, and a weaker dollar should boost affiliates' results.  Corporate America is beginning to cut capacity, which should help to exploit operating leverage and stabilize pricing.  Private credit demand may begin to rise, boosting financial earnings.  Rising oil prices should be good news for energy earnings, including those from affiliates.  And Federal Reserve profits, which are included in the NIPA measure, should rise considerably along with the Fed's enlarged balance sheet. 

Dissecting the first quarter. NIPA after-tax ‘economic' corporate profits rose 3.4% in 1Q09, the first increase in seven quarters.  The gain was a significant positive surprise, so it's important to dissect the results to assess their implications for the outlook.  The results underscore a new dichotomy between financial and non-financial earnings; previously, both had been declining since 2007; now the former are rising and the latter continue to slide.  Having plunged in 4Q to levels last seen in 1994, financial earnings nearly doubled in 1Q, retracing about two-third of their 4Q slide.  In both reports to shareholders and the NIPA data, stepped-up results in fixed income trading and mortgage originations accounted for much of the improvement, although we suspect that much of the bounce reflected one-time rebounds from depressed 4Q levels.  But earnings at domestic non-financial companies sagged by even more than sales, so non-financial profit margins declined to 6.6% in 1Q - the lowest level since the summer of 2003.  And gross earnings from abroad continued to slide, now off 24.9% from a year earlier. 

The questions now: Will the rebound in financial earnings continue?  And what will end the slide in non-financial results?

Financials improving, but face headwinds.  In our view, and that of our banks team, operating earnings at financials, including those at banks, likely will continue to improve over the next two years (see Betsy Graseck's Decelerating Deterioration Drives Lower Betas, Higher Price Targets, May 22, 2009). A steep yield curve will help net interest margins, and consolidation will help efficiencies, driving up returns on assets as non-performing loans shrink.  But the future pace may be subdued for a while, reflecting two factors.  One is cyclical: Overall loan books will continue to slide as the demand for credit remains weak for now and charge-offs mount, limiting the base from which to generate those earnings.  For example, Betsy Graseck and we expect that overall mortgage and consumer credit outstanding will slide by about 8% over 2009-11, with consumer footings at banks declining by about 4% over that period (see Deleveraging the American Consumer, May 27, 2009). 

Second, while funding markets are healing rapidly, financial institutions are unlikely to be able to use leverage to the degree used in the past, which will slow earnings growth and keep ROEs from reaching prior cycle peaks.  At work is a prolonged, cyclical deleveraging process for most financial intermediaries, reflecting credit losses and the need for higher capital buffers (see Credit Losses, Deleveraging and Risks to the Outlook, May 4, 2009).  The headwind from constrained financial leverage is likely to be more secular than cyclical, partly because the current swing in the regulatory pendulum will reinforce it.  So we believe it will restrain financial earnings growth for the next few years. 

Non-financial earnings face four cyclical headwinds.  The slide in non-financial results likely will end next year, but there are four near-term headwinds for non-financial margins and earnings.  First, operating leverage is still depressing margins, as fixed costs (primarily depreciation) are rising as a share of total costs and relative to volumes.  In addition, record-low operating rates are sapping corporate pricing power, weighing on both the top and bottom line.  Third, the dollar is still 10-12% higher than it was a year ago, translating earnings of US affiliates abroad into fewer dollars.  Finally, those earnings in local currency remain under pressure, as business activity is still sliding in some economies and only bottoming in others.

Leverage, operating rates and pricing power: Domestic headwinds.  It seems obvious, but the combination of recession and high operating and financial leverage is always lethal for earnings.  Leverage - both operating and financial - works both ways, so even a growth slowdown would have been corrosive.  Lower marginal but higher fixed costs have increased operating leverage.  When growth was healthy, Corporate America's ability to exploit that leverage propelled earnings to record levels.  Strong increments to revenue went straight to the bottom line.  Financing the boom with debt and buying back stock increased financial leverage and, of course, raised ROEs and earnings per share.  Our strategy team estimates that corporate buybacks added 250bp to S&P earnings gains in 2006, and a whopping 300bp in 2007. 

Now, of course, recession means that operating leverage is working in reverse, with decreases in revenue going right to the bottom line.  In addition, the recession has crushed operating rates, reducing pricing power.  In manufacturing, for example, operating rates plunged to record lows of 65.7% in May - more than 15 percentage points below their long-term norm.  The good news for energy and commodity companies: After plunging, prices for energy, materials and commodities are rising again, offering some margin relief.  That's bad news for profits of commodity-using industries, however; as those companies will have difficulty passing along those price hikes, the back-up in input prices will only intensify the margin squeeze.  Measured in the NIPAs associated with GDP, so-called inventory profits, which accrue when prices rise for goods held in inventory, added about 760bp to earnings growth in the year ended in 2Q08.  The reversal in such phantom earnings is subtracting a similar amount from earnings in the year ended 2Q09.  Finally, of course, deteriorating credit quality at both financial and non-financial companies is squeezing margins further, and the deleveraging of Corporate America is reducing ROEs and earnings per share.

Global headwinds.  The global recession has weakened US top-line sales by undermining exports and has eroded the bottom line at US affiliates abroad.  That contrasts with the past few years when growth abroad - and the higher oil prices that came with it - were powerful engines for US earnings.  We estimate that global nominal GDP excluding the US may contract by up to 4% in the year ending in 3Q09.  Correspondingly, earnings of US affiliates, already contracting sharply, seem likely to contract through late 2009.  Such earnings have already plunged from a record 38% of overall earnings in 4Q08 to 32% in 1Q09; S&P measures show a similar share.  Importantly, that's still double the share of 20 years ago - the last time strong global growth consistently contributed to growth in the US.  Consequently, the global impact on earnings today has doubled over the past two decades as US direct investment has spread abroad, and the recessions abroad will have a bigger impact on the bottom line than in the past. 

Likewise, the lagged effects of the dollar's erstwhile strength are depressing US earnings through two channels.  First, foreign earnings are still being translated from euros, Brazilian reals and Korean won into fewer dollars compared with a year ago.  On a broad, trade-weighted basis, the dollar is 10% higher than a year ago, and our empirical work suggests that such a rise has reduced US earnings from abroad by 3-5%.  In addition, even if bottoming, economic weakness abroad is still hurting US companies trying to recapture market share.  The intensity of the plunge in real US goods exports will soon diminish from the 14.7% slide in the year ending in March, but a return to strong growth likely awaits in 2010.  For now, therefore, these earnings headwinds will reinforce the decline in domestically sourced profits, in our view. 

Brightening picture for 2010 and beyond.  In contrast with this still tepid outlook for 2009, the picture should brighten in 2010.  Recovery at home and abroad should begin to lift margins by 1Q10.  Corporate America is beginning to cut capacity, which should help to exploit operating leverage and stabilize pricing; indeed, as in 2002-04, so-called ‘capital exit' will be a key ingredient in the coming improvement (see Capex Bust and Capital Exit, April 20, 2009).  The dollar is now sliding against many currencies, which should boost the dollar-denominated rise in affiliates' results.  Rising oil prices should be good news for energy earnings, including those from affiliates.  And Federal Reserve profits, which are included in the NIPA measure, should rise considerably, reflecting the massive increase in the Fed's balance sheet, cheap financing from excess reserves and a steep yield curve.

Global
Bond Bubble Bursts - Benign or Malign?
June 04, 2009

By Joachim Fels & Manoj Pradhan | London

Central banks and the bursting bond bubble: A key issue that central bankers in Europe and the US will have to consider at their upcoming policy meetings (ECB Council, Bank of England's MPC on June 4, FOMC on June 23-24) is the recent sharp sell-off in government bond markets. What's behind it? Is this a sign that quantitative easing (QE) isn't working after all? Could the back-up in yields derail the anticipated recovery in the second half of the year?  Should central banks' bond purchases be stepped up in response, or should they be slowed down?  Here's our take on the reasons behind the back-up in yields and its likely implications for the economy and central bank policy.

The bond roller-coaster: To put things in perspective, it is important to note that the recent sell-off in government bonds merely continues a trend that started already at the beginning of the year. Between mid-November and the end of last year, the 10-year US Treasury yield collapsed from a range of 3.5-4% to a low of only 2.05% when it became clear that the global economy was falling off a cliff and deflation fears surged.  From the low in late December, yields have now backed up by some 150bp to 3.58%, back to the range that prevailed for most of 2H08.  As we see it, there are two main factors behind the rise in yields over the past five months:

Unwinding of previous overvaluation: To a large extent, we view the rise in bond yields as the unwinding of a bond bubble that inflated late last year.  Bond yields have not shot up to unsustainable highs, but have rather bounced off unsustainable lows.  To illustrate this point, we illustrate the actual 10-year US Treasury yield along with MS FAYRE, our estimate of the fundamental fair yield.  MS FAYRE (the Morgan Stanley FAir Yield Regression Estimate) is based on an estimated long-run relationship between 10-year yields and a small set of ‘fundamentals', including the real fed funds rate, survey-based inflation expectations and inflation volatility (for an exposition of the model, refer to J. Fels, M. Pradhan, Fairy Tales of the US Bond Market, July 26, 2006). According to this estimate, yields undershot their fair value by about 100bp late last year and have since backed up above their current MS FAYRE value of 3.1%.  So, most of the back-up in yields reflects a return to fair value rather than a surge to unsustainable highs.  It is remarkable, though, that yields now exceed MS FAYRE for the first time since early 2004. Thus, the ‘conundrum' of bond yields trading below their fundamental values finally appears to have come to an end after more than five years.  However, given the standard errors of our model, the current undervaluation of bonds is fairly small - fair values have tended to attract bond yields emphatically when the deviation has exceeded 100bp.

Worries about sovereign risk: The other factor that has probably helped to push yields higher, especially recently, is worries about sovereign risk on the back of rapidly rising public sector debt in the US and elsewhere.  We think it is important to keep in mind that in countries like the US where public debt is denominated in domestic currency, sovereign risk is really inflation risk (a point made in "The Global Liquidity Cycle Revisited", The Global Monetary Analyst, May 27).  It is extremely unlikely that the US government would ever default, because it could simply instruct the central bank to print money to service and repay the debt, if needed, which would ultimately be inflationary. Bond markets understand this, and so it is wholly unsurprising that the rise in nominal yields has been more than fully driven by a rise in the inflation premium rather than a rise in real yields.  While 10-year breakeven inflation rates have surged by about 200bp since the start of the year to some 2% now, real yields have actually declined by some 50bp. 

Yield back-up to derail the recovery? We think it unlikely that the rise in bond yields will derail the (tepid) recovery we anticipate for 2H09.  This should be clear from the decomposition of nominal yields into real yields and inflation discussed above. What matters for the real economy are real interest rates, not nominal rates, and real interest rates have fallen rather than risen. In fact, the rise in inflation expectations could even provide some near-term support to demand as people may bring forward consumption in the expectation of rising prices.  Put differently, late last year, when deflation fears were widespread, consumers probably held back in the expectation of lower prices. This is less likely to be the case now that inflation expectations have normalised.

How will central banks react? In our view, the major central banks are more likely to see the back-up in bond yields as a sign of normalisation rather than something to worry about. After all, they resorted to unprecedented conventional and unconventional easing in response to the rising deflation threat. The fact that deflation fears have now abated (though not wholly disappeared) is therefore likely to be seen as a success. Also, despite the sharp rise, market-based inflation expectations are still at or even slightly below central banks' explicit or implicit inflation targets. Given the outlook for an only hesitant economic recovery later this year, the bond market sell-off is therefore unlikely to derail the QE programmes that are currently underway in the US and the UK and will be announced in more detail by the ECB on June 4. If anything, our US economists believe that the FOMC could decide to step up its purchases of government bonds and MBS at the June 23-24 FOMC meeting (see Morgan Stanley Strategy Forum, June 1).

What next for bond yields? Despite the sharp sell-off in bond yields, we think yields will drift higher still over the medium term. Our US economics team looks for 10-year US Treasury yields to rise to and above 5% over the next 12 months. Also, our interest rate strategy team expects a further unwinding of the US bond bubble (see Global Perspectives: Bonds: A Bursting Bubble? May 29). As we see it, the inflation premium at close to 2% still looks very low, given the unprecedented monetary easing and the ongoing monetisation of government debt. At 2%, markets still expect CPI inflation to be lower on average over the next ten years than it has been over the last ten (2.5%). With more signs of economic healing to come and central banks not even halfway though with their announced QE programmes, we believe that there is ample scope for a further rise in inflation expectations over the medium term. Investors who share this view may want to refer to our strategists' publication referenced above for trade ideas based on this view.

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