Savings vs.

Profits
Saxo Bank Research Note. 3rd of August, 2009. Chief Economist David Karsboel

We have for several quarters written about a change in the debt-financing

megatrend that evolved after the deregulation and budget deficit explosion in the
early 1980s. This is a further elaboration on the mega-trend change and what it
means.

First a recap of our thesis:

When Central Banks are targeting a yearly inflation of 2% (in reality 3% due to unaddressed asset
inflation) and the natural productivity growth of a capitalist economy is 3%, the money supply has
to increase by 6% per year. Such an increase in the money supply cannot be absorbed in the
economy without creating huge imbalances when it is allowed to continue for decades.
The imbalances manifest themselves in a lack of savings, excessive credit-creation and mal-
investments (since interest rates are too low). In such an environment, consumption growth is
strong, since it doesn’t pay to save and since debt-financed consumption is cheap. A positive feed-
back mechanism is at play when the bubble inflates, housing equity increases, Home Equity Lines
are being tapped and corporate profits benefit from the strong consumption. Businesses hire to
satisfy the consumers and the resulting strong wage growth supports the housing market.
The imbalances lead to a blow-off phase when this positive feedback mechanism creates a
cultural change that leads to unrealistic growth premiums in asset prices, which pushes their prices
– and thereby debt levels – too far from their fundamental value (household disposable income).
The bust comes about when the consumption growth stalls and no longer renders the investments
and projected business plans viable. Now, there is no pent-up demand; lower interest rates will
make no difference for consumption. The bubble is deflating and asset prices are reaching for
(possibly undershooting) their equilibrium prices and the positive feedback mechanism turns
negative:
1. Falling profits (since the consumption growth cannot continue without any savings) =>
2. Falling asset prices (disappointed earnings expectations) =>
3. Losses in financial institutions (writedowns) =>
4. Credit contraction (to combat insolvency) =>
5. Thinner liquidity (higher volatility and therefore margin calls) =>
6. Fire sales (to meet margin calls) =>
7. Shrinking balance sheets (to lower exposure and ensure solvency) =>
8. Falling asset prices (see point 2 and repeat the exercise)
It is important to note that this deflationary/disinflationary spiral will continue until asset prices
reach their equilibrium (this might result in undershooting). In other words, stocks should trade at
lower earnings-multiples (using net earnings – NOT operating earnings), houses should cost fewer
multiples of household incomes, and savings should be enough to ensure a steady, future trajectory
of investments and consumption.

Where are we in this ongoing change in the mega-trend?

First of all, it is important to recognize how much of the consumption (and earnings) in the past
decade have been due to debt-financing rather than true, sustainable earnings growth. Looking at
below graph, one can see that roughly 3% of GDP was extracted from the housing equity (blue line)
during the blow-off phase years (2003-2007). Those 3% were put directly into consumption.

Source: The Federal Reserve, Bloomberg and Saxo Bank Research

The problem is that US home prices are dropping like a stone and show no signs of stabilizing
(green line). That means that the mortgage debt is set to decline as well – for the first time since
the Great Depression. In other words everything else being equal, US consumption will “miss” 3% of
GDP – or since consumption is around 70% of GDP – about (3/70=) 4.3% in total in the next many
years. US Personal Consumption will find a trajectory that is permantly lower than it was until
2007.
The other side of the coin is savings. In order to make steady, sustainable growth possible, we need
a big and credible pool of real savings (not the sort of savings that everybody thought they had in
their housing equity in the blow-off phase years) – i.e. savings that are completely independent of
asset prices and that therefore work as a bulwark against changes in the business cycle. Therefore,
savings have now begun their steady march from all-time lows in the blow-off phase years to their
historical average or possibly even higher. See the graph below:
Source: Bloomberg and Saxo Bank Research
We need to see that savings reach the pre-1980 average of at least 7% of GDP. That probably means
that consumption’s share of GDP will decline (permanently) towards 62-64% of GDP from the
current 70%. But is it realistic to assume that spending can drop that much and stabilize at such a
level? In short, yes, and it is about to happen. The graph below depicts the Personal Spending to
Income Ratio over the past half century. It shows that we are about to reach the historical average
of 90%, but it might even undershoot and reach the 86% that roughly coincided with the all-time
buying opportunity in the stock market in the beginning of the 1980s.

Source: Bloomberg and Saxo Bank Research

This development will have huge implications on the financial environment. The whole corporate
sector will have to compete for a lesser pie of consumption demand and that will presumably
squeeze margins and lead to lower revenues. Looking at below graph, we can see that that is
indeed the historical relation. In other words, when the savings-to-consumption ratio rises,
corporate profits tend to decline as a share of GDP.

Source: Bloomberg and Saxo Bank Research

This whole discussion became very relevant with the release from the Bureau of Economic Analysis
showed that the US Savings Rate as a percent of Disposable Household Income rose to 6.9% - the
highest since 1993. The problem with the savings rate as reported by the BEA is that it does not
include the paying off of debt, which in an economic sense is just as much a savings activity as
putting money aside for a rainy day. If we include the increase or decrease of household and
corporate sector debt in the measure for savings, we get the picture in the below graph:
Source: Bloomberg and Saxo Bank Research
Note the strong, negative correlation (right axis is inverted) – except in the 2000-2002 meltdown
where extremely loose monetary and fiscal policies led to massive debt-creation. This development
stabilized the US economy in the short-term, while creating an even greater bubble in credit and
housing markets in the aftermath. If total Savings Activities are returning to their pre-1980 average
of around 6% of GDP, Corporate Profits are likely to decline towards 7%, which is far away from the
rosy expectations about a V-shaped recovery currently priced into equities.

Conclusion
The bad news is that the earnings recession is far from over. Earnings and businesses in general will
have to adapt to the new economic landscape of savings. That means cost-cutting, streamlining,
wage deflation, unemployment, capital destruction and margin-squeeze across the board.
The good news is that the macro economy – despite many government efforts to stop this process –
is now finally on its course towards a long-term, sustainable equilibrium. We will return with more
details later on how such an equilibrium might look.