Debt, Corporate Profits And Economic Thoughts

by: Pat Stout

It is tough avoiding the negative characterization of the debt market, isn't it? Many in the media and Congress rail daily against the size of the U.S. debt. The mantra appears to be the debt is bad, right? It is good to look at debt levels but like many things in the financial markets the pendulum can swing too far in either direction. For example, how many of us could afford the home we live in without debt financing and if we could, what would happen to the financial industry?

Take a close look at the chart below of Gross Federal Debt and Corporate Profits. Notice how they rise together? It can be tough for debt to decline as it is generally a longer-term obligation while corporate profits are a quarterly event.

Corporate Debt versus Gross Federal Debt.

I could be wrong but it would appear that the government is becoming more like business when it comes to the issuance of debt.

A lot of talk over the size of defense spending. The chart below shows corporate profits after tax and defense spending as a percentage of corporate profits after tax.

Looking at bond and stock yields, notice how after the Great Depression stock yields generally exceeded bond yields. I would argue from the basic economic principle of risk and return that stock yields should exceed bond yields. Stocks are more risky than bonds, aren't they? Unlike a stock a bond become less risky with each passing year as interest is earned and the duration declines as the maturity date become closer. This is not to say that bonds cannot product negative returns, they can as investors old enough to remember the 1970s can vouch. Corporate bond investors might recall the LBO of the 1980s.

Might bonds enter a prolong period of a narrow trading range? Or enter a period of gradual yield increase? The Bond Bubble crowd might be thinking of the more recent past, rather than what happened after the Great Depression. TARP was enacted over fears of another Great Depression, right? So wouldn't the rational view be to look at what happened after the Great Depression?

Commercial banks have more cash on hand than C&I loans outstanding. There could be rational reasons for holding large cash balances. How easy was securing or rolling over debt in the 2007 to 2010 time frame? If it was so easy then why was TARP required?

Corporate Profits compared with State and Local Property Tax and Sales Taxes. It would appear that the relationship changed around the turn of the century.

What some investors might be missing or discounting is the tailwind that corporations can enjoy from lower interest expense. Each dollar not paid in interest to bondholders is income that drops down to the bottom line. In 2000 Goldman Sachs (NYSE:GS) had interest expense of $4.8 billion at the parent company level. By 2011 the interest expense line was $3.9 billion. That is a $900 million cost savings.

In 2007 the interest expense for Goldman Sachs and its subsidiaries was $41.981 billion. In 2011 interest expense had declined to $7.982 billion. That is a savings of $33.999 billion. Over a decade the savings (reduced spending) could approach $340 billion.

Bottom line, the economy is improving, if the January 2013 budget surplus is any indication. There are a number of other signs showing improvement, which I shall save for a later article. I shall wrap up this article with the observation that high cash balances can be a good thing, and that it will take time for consumers and business to stop fearing another economic and or financial market collapse. In many ways today's economy reflects more of a natural rate of demand driven by current earnings rather than the mid 2000s' debt-fueled binge.

Let me know if you agree or disagree.

Source for charts: St. Louis Fed

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: I am long Goldman Sachs preferred issues for the income and would like Goldman to be profitable.