Over the course of the last 18 months I’ve been adhering to a macro view that can best be summed up as follows:
- The explosion in private debt (excessive housing borrowing, excessive corporate debt, etc) levels would reveal the private sector as unable to sustain positive economic growth, de-leveraging and deflation would ensue.
- Government intervention would help moderately boost aggregate demand, improve bank balance sheets, improve sentiment, boost asset prices but fail to result in sustained economic recovery as private sector balance sheet recession persists.
- Extremely depressed estimates and corporate cost cutting would improve margins and generate a moderate earnings rebound, but would come under pressure in 2010 as margin expansion failed to continue at the 2009 rate.
- The end of government intervention in H2 2010 will reveal severe strains in housing and will reveal the private sector as still very weak and unable to sustain economic growth on its own.
The rebound in assets was surprisingly strong and the ability of corporations to sustain bottom line growth has been truly impressive – far better than I expected. However, I am growing increasingly concerned that the market has priced in overly optimistic earnings sustainability – in other words, estimates and expectations have overshot to the upside.
What we’ve seen over the last few years is not terribly complex in my opinion. The housing boom created what was in essence a massively leveraged household sector. The problems were compounded by the leveraging in the financial sector, however, this was merely a symptom of the real underlying problem and not the cause of the financial crisis (despite what Mr. Bernanke continues to say and do to fix the economy).
As the consumer balance sheet imploded the economy imploded with it. This shocked aggregate demand like we haven’t seen in nearly a century. This resulted in collapsing corporate revenues. The decrease in corporate revenues, due to this decline in aggregate demand, resulted in massive cost cutting and defensive posturing by corporations. This exacerbated the problems as job losses further weakened the consumer balance sheet position. Consumers, like, corporations, got defensive and began cutting expenses and paying down liabilities. Sentiment collapsed and we all know what unfolded in 2008.
The government responded by largely targeting the banking sector based on the belief that fixing the banks would fix Main Street. Accounting rules were altered, bank balance sheets were altered and the banking recovery ensued. The government stimulus package bolstered the economy in several ways. Most importantly, it brought some confidence to the economy. In addition, the Recovery Act helped bolster aggregate demand as government spending helped offset some of the reduced spending power of the private sector. The Fed’s actions helped bolster bank balance sheets, but has done almost nothing to help Main Street. Most notably, government intervention has failed to target the actual cause of the crisis – the crisis in the Main Street balance sheet.
That’s the 30,000 foot view of what we’ve been through up until now. What’s disconcerting about the current environment is that the tide is coming in and as I expected the private sector is swimming nude. In other words, the private sector remains mired in a balance sheet recession that has resulted in abnormally low levels of aggregate demand and therefore weak corporate revenues. Sustainable corporate expansion is the missing piece of the recovery puzzle. The government has largely papered over this weakness by crediting private sector bank accounts and foolishly propping up the wrong sectors of the economy (auto sales via cash for clunkers, housing via homebuyers tax credits and banks via bank bailouts). As the stimulus ends the private sector is being revealed for what it has been this entire time – abnormally sluggish.
The outlook going forward remains increasingly fragile in my opinion. As I mentioned in March and last week the private sector is in no condition to sustain recovery. The debt levels simply remain too high. There remains a substantial gap between income and liabilities and the household financial obligation ratio therefore remains higher than at any point in the last 25 years:
What makes the current environment particularly alarming is the increasing divergence between the macro outlook and the earnings picture. The market has remained relatively robust in recent months despite an onslaught of negative news, however, any signs of weakness in corporate earnings will likely change that. The corporate earnings picture is looking increasingly precarious.
Over the last 18 months we have seen a moderate recovery in corporate revenues as government spending picked up the slack and confidence surged from the lows. As the government stimulus ends the modest revenue recovery is at risk of running into a wall. More alarming is the likelihood of a stall in corporate profit margins.
Unit labor costs have fallen dramatically in the last 18 months as companies have reduced their largest expenditure. This has resulted in stronger than expected earnings. As the government based recovery unfolded corporations have slowly begun to hire or at least stop firing workers. Unit labor costs have begun to rise modestly as a result.
This leaves the equity markets in a precarious situation. The macro outlook appears to be deteriorating in recent months, however, the private sector is in no place to maintain the necessary level of aggregate demand that can sustain the recovery in corporate revenues. With revenues likely to slow and margin expansion likely peaking there is increasing risk of further defensive posturing from corporations.
If the macro outlook deteriorates further (none of this even considers the very serious exogenous risks from China and Europe) the private sector balance sheet will further deteriorate as layoffs ensue. Assuming no further government intervention the balance sheet recession is likely to persist well into 2011. If the divergence in earnings materializes equity markets will remain under pressure. If an exogenous event shocks the markets (eurozone sovereign debt concerns for example) the equity markets could deteriorate substantially.