GMO's James Montier Explains The True Source Of Today's 'Freakish' Corporate Profit Margins

One of the hallmarks of today’s economy is the gap between the gains accrued to shareholders and the gains made by workers in the recovery.

This gap has manifested itself in record corporate margins and massive piles of cash.

So what gives?

In a new-must read, GMO portfolio strategist James Montier delves into the origin of this issue.

Today I find myself once again digging through this toolkit, searching for a way to understand the development of profit margins. Currently, U.S. profit margins are at record highs according to the NIPA data. More freakish still is that these record high profit margins are coming during the weakest economic recovery in post-war history.

Here’s a look at said margins.

Click to enlarge


Photo: GMO LLC

What’s crucial here, from the perspective of investors, isn’t just that margins are above previous highs, but that current earnings projections assume they’ll go even higher (At least as of late last year)!

Click to enlarge.


Photo: GMO LLC

So what’s the source of these incredibly high margins, and can they really persist?

Here Montier gets into the basics of the flow of funds and the national accounts, and he bases his work on the economist Michael Kalecki, who identified this simple equation:

Income = Expenditure

That seems obvious, but it’s a good starting point to recognise that every dollar spent represents income for someone else.

Montier then notes that income equals profits and wages and that expenditures are divided into investment and consumption, so the above equation actually turns into…

Profits = Investment + Consumption – Wages

That gets permuted some through a few more steps, so that ultimately the equation for profits turns out to be:

Profits = Investment – Household Savings – Government Savings – Foreign Savings + Dividends

And with that equation we can finally start figuring out the source of those monster profits.

This is how things looked like in 2011:


Photo: GMO LLC

See the big source of profits? Yep, it was the government’s monster negative savings. Or to put it another way, it was the huge deficit equalling 7.6% of GDP that really boosted corporate profits.

Now what you have here is the justification for huge government deficits. Following the crisis, the private sector balance sheets were badly damaged, and government deficits have done wonders towards boosting GDP and corporations. 

The title of Montier’s piece is: What Goes Up Must Come Down!

If you think that the deficit will inevitably shrink, then to maintain profits, something else has to change. Can consumers afford to save less? Can we shrink our trade deficit? Will there be a reason for investment to jump?

Hope so.

Click here to read Montier’s whole letter (.pdf) >

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