Yesterday we wrote about Jonathan Chait’s assertion that the Fiscal Cliff is an event that moves policy far to the left, and that that explains why conservatives and corporations are freaking out so much about it, even though it reduces the deficit significantly.
Chait’s analysis focused on the tax implications of the Cliff, the fact that all taxes would revert to their Clinton-era levels on January 1, 2013, an outcome that makes conservatives queasy.
But there’s another reason the Fiscal Cliff matters to corporations that goes beyond taxes…
You’ve probably seen this famous chart of Corporate Profits as a share of GDP. It’s a pretty rough approximation of corporate profit margins, and it shows that margins are very close to an all-time high. Not only are they at an all-time high, but they’re way out of line with recent decades.
In a brilliant piece written this past march, James Montier explained why margins were so high.
In his analysis he includes the chart below, which is what every investor needs to see.
It shows the various drivers and drags on corporate profitability. So for example, household savings are always a drag on profitability, since that’s money not spent to buy goods. Net investment helps boost corporate profitability, since that investment will flow to the profit line of another corporation. When the government is in a surplus, that reduces corporate profitability, since that means the government is taking in more than it pays out. When the government is in deficit, that boosts profitability.
As you can see in the chart, what REALLY stands out is the huge explosion of the red area (representing government deficits), helping to drive corporate profits at a time when nothing else is doing the work.
Drawing on a similar idea, back in April, John Hussman posted this chart, which compares corporate profitability to the inverse of government and household savings (with a lag). In other words, when government and household savings decline, the red line goes up. A few months later, the blue line (corporate profits) follow nicely.
Bottom line: The deficit is a major driver of corporate profits.
Investors need to take note that a sharp, sudden decrease in them could mean murder for the bottom line.