Profits over the past couple of decades have inflated to bubble-like record highs, and investors should expect them to decelerate or even decline over the next couple of decades.
That gloomy long-term forecast comes from Research Affiliates’ Chris Brightman in the Rob Arnott-led firm’s recent newsletter, but the profit warning comes with an unusual political twist:
Much of Brightman’s analysis emphasizes that today’s high level of corporate profits violates people’s sense of social fairness, accounts for rising populism and all but assures that “corporations’ labor, interest and tax expenses [will] rise faster than sales over the next couple of decades” while profits decline.
The profits bubble discussion comes at a time when the stock market hovers near its all-time high after a long bull run, leading many commentators to think a correction is overdue, while some bulls, like Wharton professor Jeremy Siegel, argue that corporate earnings fully justify today’s stock market valuations.
But what gives Siegel reason to celebrate is cause for deep concern on Brightman’s part. Profits, he warns, are “dangerously” elevated, with S&P 500 real earnings per share far above trend, profit margins at or near record levels and profits as a percentage of GDP and relative to labor income at or near all-time highs.
Capital’s share of income relative to wage earners seems socially unsustainable, he says, predicting that “social and political forces, if not economic developments, will cause it — sooner or later — to revert to a more usual level.”
Brightman, head of investment management for the Newport Beach, Calif.-based indexing firm Research Affilliates, warns that investment professionals should beware the human tendency to uncritically assume that the future will accord with the conditions they have known in their careers.
While “a multi-decade period of zero or negative growth in real earnings per share” needed to reduce corporate profits’ share of GDP may seem preposterous to many, history is replete with examples of sustained profit weakness, he says—the 1970s and 1980s being the most recent.
Brightman points out that the most recent profit bubble to end badly, in 2007, may now be exceeded by 2013 in real earnings per share (EPS) terms, and our current profits boom may now be the second highest in history.
The record holder, in 1916, was followed by a 39-year lull till the next profits peak in 1955, and Brightman points out that two world wars and a Great Depression came in the intervening years.
Brightman traces the current profits explosion to the effect of globalization that started in the 1990s, when quite suddenly China, India, Russia, Eastern Europe, South America and Southeast Asia added 3 billion people to the decades-long stasis during which North America, Europe and a few other countries lived amid economic and technological plenty.
That “seismic shift” quadrupled the advanced economy’s labor force, thus dramatically lowering global poverty while at the same time causing wage stagnation in the old advanced economies — all while bolstering corporate profits to near record levels.
Brightman argues that “corporate capture of government policy” has greatly facilitated globalization and its accompanying profits inflation.
“Rent seeking may be more extreme within our very own financial industry than in any other,” he says, citing the Troubled Asset Relief Program and quantitative easing as prime examples of government policy that has benefited corporate interests.
“For several decades, under governments led by both parties, the close nexus between Wall Street and Washington has facilitated an economic policy that favors politically savvy corporations and too-big-to-fail megabanks,” he writes, noting the “sheer coincidence” between government policy and the Street’s large campaign contributions.
The investment industry exec takes pains to state his appreciation of “business success” and abhorrence of “government meddling in the economy,” but in a rhetorical style not usually found in investment letters adds:
“Because globalization and corporatist economic policies seem to have unfairly tilted the scales against lower skilled workers in developed countries, we sympathize with the growing political pressure to subsidize the creation of low-skill jobs, to improve the skills and wages of the less proficient, and provide a living wage to the working poor.”
The Research Affiliates head of investment management foresees a decades-long profits bust, emphasizing the growing role of political change in economic policy:
“We cannot predict the quarter or year when profits will peak," he says. "We can predict the catalyst. The share of corporate profits is a political choice.”