Deleveraging threat to profits

UK profits are falling. Last week's official figures show that the share of profits in national income fell to a ten-year low in Q2. Since real GDP peaked in 2007Q4, profits have fallen six per cent in nominal terms whilst wage incomes have risen 10.7 per cent.

In part, the fall in profits in Q2 was due to temporary factors. The closure of the Elgin gas field and the extra bank holiday in June hurt profits more than wages, and there's traditionally a cyclical element to the profit share: it often falls in recession and rises in recoveries.

Nevertheless, I suspect there is a longer-lasting danger to profits. You might think it comes from our productivity slowdown; if firms are employing more workers to produce the same amount, costs are higher so profits must be lower.

This view is wrong. It's the fallacy of composition. Yes, higher wage costs are a problem for any individual firm. But they are not necessarily a problem for all firms in aggregate. This is because one firm's costs are another's revenues. If workers spend their extra incomes, then what employers in aggregate lose from costs they gain from higher spending.

However, this thinking draws our attention to the bigger danger to profits. To see it, let's remember a national accounts identity. GDP is the sum of wages (W), profits (P) and taxes (T). It is also the sum of consumer spending (C), investment (I), government spending (G) and net trade (X – M). This allows us to express profits thus:

P = (C – W) + I + (G - T) + (X – M)

This immediately alerts us to the danger. If C falls relative to W, then (ceteris paribus) profits fall. This is just what happened in Q2; wages rose 1.8 per cent, but consumer spending rose only 0.3 per cent. Profits fell because firms' increased wages did not returns to them in the form of increased consumer spending.

And this might continue. If households do want to deleverage and reduce their debt, then C will fall relative to W, depressing profits.

Now, that "ceteris paribus" is doing some work here. In practice, lower consumer spending (I stress relative to wages) would also mean lower VAT revenues and lower imports. But it's improbable that all the pain of households' deleveraging would fall upon foreigners and the public finances.

Our identity warns us of a further threat to profits. It's that (G – T) term. It tells us that a reduction in the government deficit tends to reduce profits.

In a sense, this is a separate threat from households' deleveraging, because government attempts to deleverage could frustrate households' attempts to do so. As fiscal austerity depresses incomes, households would simply lack the wherewithal to pay down debt. But this would hardly be conducive to good profits growth.

Of course, the government hopes that fiscal retrenchment - most of which has yet to happen, remember - will be accompanied by "rebalancing", in which investment (I) and net exports recover.

But this is only a hope. It's possible that the opposite will happen. It could be that the US is silly enough to fall off its fiscal cliff at the same time as fiscal austerity in southern European holds back euro area growth. In this event, (X – M) won't rise much as (G – T) falls. And if this happens, investment won't rise either. Weak global growth, allied to domestic deleveraging and fiscal austerity, is the environment in which firms would reduce capital spending, not increase it.

My point here is a simple one, but which I fear investors often overlook. It's that deleveraging - by households or governments here or overseas - is a big threat to profits. If you agree with David Cameron that "the only way out of a debt crisis is to deal with your debts", then you should be pessimistic about profits.

Stock market bulls should hope that households do not try to repay their debts too much.

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