The Market’s Tailwind Is Gone
by David Reavill
For the past 14 years, American Corporations have received an incredible boost in earnings. An increase may have contributed up to one-third of their profit growth over the past 14 years.
Our story began in the Financial Crisis of 2008. At least one of the country’s significant money-centered banks, Citibank, was at risk of insolvency. In a time of grave uncertainty, Many felt that our entire financial system was at stake.
For years mortgage brokers had made aggressive real estate loans to high-risk individuals who, in 2008, were defaulting. Brokers then packaged the Individual mortgages into a tranche called Mortgage Back Securities (MBS) to make them more marketable and reduce their risk. Unfortunately, so many individuals began to default that even the largest of all banks was now at risk.
The Federal Reserve responded by lowering interest rates. Rates went so low that they were at virtually zero. Suddenly there was no cost to borrow at all. With the cost of funds gone, banks could return to making affordable loans and repairing their balance sheets. Low rates certainly helped the banks immeasurably.
But the rest of Corporate America also noticed these zero borrowing costs. Now, an ordinary corporation could secure one of these zero-rate loans and raise capital with little to no cost. Immediately corporations took as many short-term loans as they could. And it wasn’t long before some of the most aggressive CEOs saw that they could replace their entire capital structure with nothing but zero-interest loans.
That’s how the massive stock repurchase programs began. Now some of the wealthier companies did buy back stock from cash. But for most, they used loans to buy out shareholders. These loans were lower cost than most dividends, and they didn’t go to the annual meeting to object to the CEO’s latest wiz-bang initiative.
So that was part of the incredible tailwind corporate America has enjoyed over these last 14 years: A rock bottom cost of capital due to low-interest rates.
The second tremendous boost to Corporate Income Statements was the “Tax Cut and Jobs Act.” The Act was the premier tax reform under Donald Trump and one of his significant accomplishments as President. Enacted in 2017, this Act lowered effective Corporate Tax Rates from an average of 35% to just 21%, providing a tremendous boost in business income.
So from 2008 until earlier this year, corporations in America have had one of the most favorable taxes and interest rate environments ever. Low, almost zero cost of capital, together with tax rates that were a third lower than prior. What’s not to like?
The bad news is it’s all coming to an end. As you know, those zero-interest rate loans are long gone. The current Fed Funds Rate, the benchmark used by the Federal Reserve to set all other interest rates in the county, is currently 3 1/4%. And likely to hit 4% when the Fed meets again in November.
Also, President Biden promised in the Campaign to raise the Corporate Tax Rates again. The next couple of months presents an opportunity to do that while the President’s party is in power.
All this came to mind when reading a recent paper by Michael Smolyansky over at the Federal Reserve. Mr. Smolyansky has estimated that these two factors, low to zero cost of funds, combined with lower corporate taxes, accounted for one-third of corporate income over the past 14 years. (https://www.federalreserve.gov/econres/notes/feds-notes/the-coming-long-run-slowdown-in-corporate-profit-growth-and-stock-returns-20220906.html)
Smolyansky concludes that those former tailwinds are now working against us. We’ve already witnessed the headwind in interest rates, with every likelihood that we will also see headwinds in corporate taxes.
We will see the final reading for Corporate Profits in the second quarter in just a few minutes. Today’s Report is from June 30, when the Effective Fed Funds Rate was only 1%. Still, in this preliminary estimate, profits fell by 4.9%. Today will be the final revision on Profits, and I expect to see little change.
So, it will be the following Report, for Q3, that we’ll likely see a significant drop in profits if Smolyansky is correct.