Farr: Funding the Deficits and Earnings Risks
In a sign that the insatiable demand for US Treasury bondsmay not remain so indefinitely, the Treasury Department announced the creation of a floating-rate note program Tuesday.
Floating-rate notes work like adjustable rate mortgages: the interest rate gets adjusted up or down, at certain intervals, in keeping with the market level of interest rates. Should interest rates fall, the Treasury Department would save on its financing costs as the rates it must pay to investors are reset lower. However, should interest rates rise sharply (perhaps in response to a surge in inflation created by the unprecedented amount of Fed stimulus), the Treasury would be stuck with a much higher interest bill.
Does this strike anyone as irresponsible?
Shouldn’t the Treasury be taking advantage of the current rate environment by locking in low rates for as long as possible (just like we’ve all done with our mortgages) rather than committing to pay an unquantifiable amount of interest in the future?
The answer to both questions should be ‘yes.’
However, the Treasury is really doing the only thing it can do to continue to fund the trillion-dollar plus deficits we have been running for the past four years. Effectively, the Treasury is engaging in Field-of-Dreams deficit financing (“if you build it, he will come”). Because the massive supply of new Treasury bonds is highly likely to exceed demand, the Treasury is asking investors what they require in order to continue buying US government securities. Obviously, the biggest risk in owning government bonds is that interest rates will skyrocket (higher rates means lower bond prices). Investors naturally will seek to insulate themselves from such a possibility. Floating-rate notes achieve this objective.
The Treasury’s need to offer floating rates to attract investors should send a clear message to Congress. The message is that the days of financing trillion-dollar deficits cheaply may be drawing to a close. We will not be able to benefit from Europe’s misery forever. At some point, a lack of crisis in other parts of the world will, by itself, lead to significantly higher interest rates in the US. When that time comes, it may be too late.
On another topic, Monday's Wall Street Journal ran an article entitled "US Profit Streak Hit by Global Weakness". The article talks about the sharp deceleration in profit growth among large US multinational companies, the kind of companies we typically find within the S&P 500 index . "In the third quarter, earnings by companies in the S&P 500 are expected to shrink for the first time since just after the recession ended, according to Thomson Reuters, which surveys Wall Street analysts." The article goes on to attribute the earnings decline to several different factors, among which are the weakening economies in the US, China and Europe, declining consumer confidence in the US, lower commodity prices (which hurts earnings at oil and mining companies), and the stronger US dollar (which hurts exports).
But the article skates around the elephant in the room: US corporate profit margins are at record highs.
We have talked about this aspect of the economy in several past market commentaries, including our first quarter edition of The Farr View. We have noted that this metric for the health of the corporate sector is one of the most mean reverting of all economic gauges. However, corporate margins, now over 10%, are more than double their average during the 75 years through 1999. Below we show a chart that was included in a recent white paper by James Montier at the asset management firm Grantham Mayo Van Otterloo.
What is the connection between our massive deficits and surging corporate profit margins? If you believe James Montier, the connection is that the surging deficits are at least partially responsible for the surging margins. In the absence of private investment following the Great Recession, the government moved in to fill the void. In doing so, corporate margins were driven to all-time highs.
In spite of share prices climbing on optimism over additional stimulus from the Federal Reserve (who are meeting this week), this does not strike us as a time to become aggressive. Being the best house on a bad street is of some comfort, but in the context of our global neighborhood, we must recognize the importance of attending to our own property. We cannot rely on our neighbors to do our weeding and yard-work for us. Preserving capital and accepting reasonable returns for a bit less risk seems prudent.
Michael K. Farr is President and majority owner of Farr, Miller & Washington, LLC. He is Chairman of the Investment Committee and is responsible for overseeing the day to day activities of the firm. Prior to starting FM&W, he was a Principal with Alex Brown & Sons. Mr. Farr is a paid Contributor for CNBC television and has appeared on numerous broadcasts and has been quoted in global publications. He is a member of the Economic Club of Washington, DC, National Association for Business Economics, The World Presidents’ Organization, and The Washington Association of Money Managers. He is the author of "A Million Is Not Enough," and "The Arrogance Cycle."
Mr. Farr is a paid Contributor for CNBC television and has appeared on numerous broadcasts and has been quoted in global publications. He is a member of the Economic Club of Washington, DC, National Association for Business Economics, The World Presidents’ Organization, and The Washington Association of Money Managers. He is the author of "A Million Is Not Enough," and "The Arrogance Cycle."