Many investors have been surprised by the strong rise in equities since March. There is, however, an underappreciated justification for the rally. It’s that there is about to be a huge support for corporate profits across the western world – in the form of increased government borrowing.
The US’s Congressional Budget Office (CB0) estimates that the government will borrow $3.7 trillion (£3 trillion) in the current fiscal year. That’s $2.7 trillion (13 per cent of GDP) more than it predicted in March. And in the UK the Office for Budget Responsibility (OBR) expects borrowing this year to be £273bn (11.5 per cent of GDP) more than it forecast in March.
A lot of this borrowing will boost profits.
To see why, recall some basic national accounts arithmetic. This says that GDP is the sum of consumer spending (C), investment (I), government spending (G) and net exports (NX). It is also the sum of incomes: wages (W), profits (P), taxes (T) and other incomes such as those from self-employment and rent (O). We can rearrange these identities to give us one for profits: P = (C-W) + I + (G-T) + NX – O.
My chart shows how these counterparts have added up to the share of UK profits in GDP since 1990. It shows that C-W has been the biggest contributor to profits, followed by G-T, with investment net of other incomes and net exports doing little.
Now, this is only an identity describing domestically generated profits of all businesses (whether listed on the stock market or not) and our measure of government spending and taxes is different from those used by the CBO and OBR. It is, however, a useful way of organising our thoughts about how aggregate profits change.
This equation tells us that other things being equal (a caveat I’ll come to) there are two great supports for corporate profits. One is G – T, government borrowing. The other is that some other incomes will fall. Freelancers and the self-employed are in the frontline of companies’ efforts to cut costs. And as small businesses go bust customers will – when the lockdown is ended – switch to larger ones. The closure of independent coffee shops, for example, will benefit Costa and Café Nero.
Against all this, however, there is an obvious negative: capital spending (I) has collapsed.
As for net exports, the salient thing is that exports and imports are both collapsing. The gap between them, however, probably isn’t changing much.
This leaves a big uncertainty: what will happen to C-W?
Here, there are three very different groups. Some of us are forced savers. I’m still getting paid by the IC, thereby depressing corporate profits, but because so many shops are closed I cannot recycle my income to the benefit of the profits of other companies. For me, and millions like me, C-W has fallen, which is depressing aggregate profits.
A second group are those for whom C-W hasn’t much changed. These are those who have suffered a loss of hours or furloughing on less than full pay and whose spending has also fallen.
The third group are those whose C-W has risen as they lose their jobs but maintain some spending thanks to welfare benefits, increased borrowing or running down savings.
Figures from the Bank of England suggest that, in March, forced savers were the dominant group. Households built up their cash savings by more than usual in the month, repaid some debt on their credit cards and other consumer loans. C-W thus probably fell in aggregate in March. With investment also falling and government borrowing not yet having risen, this suggests that profits fell in the quarter.
But this is changing. In the US, employment fell by 20.5m in April alone, with a further fall expected in May. While job losses in the UK are not expected to be so dramatic, the Bank of England nevertheless expects the unemployment rate to double this year. Nor will unemployment fall back quickly as the lockdowns end. The Bank of England expects the official jobless rate to be 7 per cent even next year: the OBR is only slightly more optimistic, foreseeing a 6 per cent rate. And in the US the CBO expects the unemployment rate to be over 10 per cent next year compared with under 4 per cent before the crisis.
This will tend to raise C-W. What’s more (and better), as the lockdown is lifted the C-W of those of us who are currently forced savers will rise – perhaps substantially so as the lockdown has created pent-up demand.
Net, then, we could well see a big rise in profits later this year as government borrowing rises and C-W recovers. This would be especially the case if capital spending also sees a post-lockdown upturn.
Of course, this aggregate hides a huge variation in individual companies’ fortunes. This might work to the benefit of listed firms, however. These tend to be larger and more cash-rich than others and so are better placed to survive the downturn and enjoy not just rising profits later this year, but also increased monopoly power.
We have, therefore, good reason to hope that profits will bounce back, perhaps very strongly at least for the survivors. You might think it troubling that they will do so only thanks to huge state aid. But this merely reminds us that the last thing that equity investors need is a free market economy.
