James Montier Explains Why Corporate Profits Keep Going Up

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1:22Hello and welcome to another episode of the All Thoughts Podcast. I'm Traci Allaway. And I'm Joe Weisenthal. Joe, you know what's a hot topic at the moment? don't say AI I mean it is right but I guess it is yeah okay AI we're not talking about AI we're talking about another hot button topic which is corporate profits yes but it might kind of be related valuation stocks booming profits booming etc like there might be some connection right okay that is fair but one of the reasons everyone's talking about corporate profits at the moment is because obviously there is this new idea that maybe there is profit-led inflation, companies raising their prices a little more than they have to given input costs and things like supply and demand, and that's boosting profits.

2:14So you see it everywhere now. And one of the things that you see is corporate profits have been very, very high in recent years, although it's true they are starting to come down. Right. Right. And the interesting thing about high corporate profits is that there has been this expect. It's been for years. I mean, they've been very high in recent years. But I mean, I remember, you know, years ago, people talk about corporate profits being high and they had to mean revert. Right. Yeah. There was this assumption that they were at unsustainable levels. And people talked about this in the wake of the great financial crisis, that corporate profits were very high.

2:49And it was only a matter of time before labor would take a greater share out of profit, et cetera. Anyway, the point is, though, they've been high and they've stayed high. I'm glad you mentioned mean reversion, because today we have really the perfect guest. We have someone who forecast that profits were going to mean revert. They were going to fall. This was a prognostication that was made back in the very early days of 2012. So right after the 2008 financial crisis, when everyone was sort of scratching their heads about why the recovery The economic recovery was slow and painful, but the recovery in corporate profit margins was quite quick and dramatic.

3:30So this particular guest made the forecast that eventually profits would mean revert. However, it is now more than 10 years later. They didn't mean revert. And our guest has just published a giant mea culpa, which is something that you don't see that often in the world of financial research. So kudos to the guest for doing that. And we are going to dig in about why corporate profits remain so high. I can't wait. This is a really important topic. And again, with this sort of new boom in the stock market really over the last couple of months again, kind of, you know, we're at a bull market again with stocks last October, last fall, really negative.

4:09Just absolutely on a tear lately, recording this June 15th. What's driving it, how sustainable it is? These are great questions to dive into now. Yeah. And we're going to talk about valuations, too, because, of course, profits, valuations sort of naturally go together. But without further ado, I think I already gave it away, but we are speaking with James Montier. He is, of course, a strategist over at GMO, someone we've wanted to talk to for a very long time. So I'm glad we could finally have him on. James, thanks so much for joining AuthLots. Thank you very much for having me, guys. Really appreciate it.

4:41So I want to sound genuine here. I really applaud someone revisiting their previous work and thinking about it again and saying, having the honesty to say I was wrong. So talk us through just to begin with, how did this sort of mea culpa come about? So I guess it really stems from just a longevity in the business. When you've been in it as long as I have, you cannot possibly claim to have anything approximating a kind of good track record for forecasting. And I've written before many, many years ago when I was back at Dresner on the folly of forecasting and how stupid it is to actually attempt to forecast things.

5:21And yet I still do it. And I think if one's going to do that. There's a whole industry dedicated to doing it. So you're not the only one. Absolutely. Yeah. The entire financial industry seems to think it can tell the future. We make gypsies with their crystal balls look positively reasonable with our accuracy. And so I've long, long taken to the view that we really have to go back and examine our mistakes. Right. There's this concept of the growth mindset that Carol Dweck wrote about years ago. And it really is that the only way of learning is to embrace your mistakes. If you get it right, fine, you got it right, but you don't learn anything.

5:56If you get something wrong, there's the opportunity to learn something. Why did you get it wrong? And so for me, as I've gone over the years, and I guess I've aged and an ego has died, that kind of enthusiasm of exuberance of youth where you're like, yeah, I'm invincible. I'm always right. And you're like, no, the markets just wear you down over time. You've been wrong. And I think what's particularly fascinating to me is when you have a long-term forecast, you know, the short-term ones are just noise, right? Any good, even if you write tomorrow, who knows? But the long-term views where you talked about mean reversion in your intro and mean reversion doesn't happen, that really gets interesting to me.

6:35And I've always kind of taken those examples of where I've been wrong 10 years after the fact and said, OK, what on earth did I miss? Because for me, it's all about learning. How do I improve? I'm 52 years old this year, and I'm still stupid enough to think that I can learn and maybe get better. I probably won't get better, but at least I can learn. So why don't we go back to start? Why don't we go back 10 years or a little more, I guess, to your call in 2012? And at the time, there's a chart in your newest white paper that's useful. It shows that at the time when you sort of first sort of rang the alarm about corporate profits, U.S.

7:16NEPA profit margins is a share of GNP. They're about 10 percent, which was well higher than anything we had seen in, say, the 50 years or I guess 70 years prior. They're sort of gotten as high as 9 percent, but they had gotten really high at that point. So why don't we start there? Like, talk about the conditions that had gotten us in 2012 to an extraordinary high level of corporate profit margins. Sure. So the framework I tend to use to understand these things is something called the Kolecki equation. Which many of our many odd lots listeners, we did a full episode on Kolecki and we. Kolecki tribute.

7:54Yeah. So this is home turf for odd lots listeners. But yes, keep going. Exactly. Yeah. Good old Jan did all the hard work for me. And I was fortunate enough when I was at university all those years ago to have someone who actually taught this stuff and arrogant enough at the time to ignore it. Back then, I was a full believer in rational expectations and I was a mathematical and columnist. And, you know, the beauty of rational expectations was really awesome to me. And then I realized as I began my career in finance that actually that was just a terrible, terrible framework for thinking. and I fell back on these tools that I'd been taught that I'd kind of thrown out when I was being taught them.

8:31In fact, I saw my old lecturer a good few years ago, sadly, at a funeral and had to apologize to him for my extreme arrogance when I was a student and tell him that the stuff he'd actually taught me was the only stuff I actually use these days. And I used this equation to kind of frame the world and try and understand profits. And it comes down to this view that profits can really be decomposed from a macro point of view. The beauty of a macro framework is it imposes conditions that tend to get missed when you're dealing with micro topics. So often you'll hear people say, oh, now, profit margins are high because they crushed their suppliers.

9:09Well, the problem is, from an aggregate point of view, that doesn't make any sense, right? It might be true for that one individual company, but it can't be true in aggregate because those - The suppliers and profits too. Also, companies, right? Yeah, exactly. They get their inputs. So everybody's output is somebody else's input kind of thing, right? So you can't get higher profits by squishing in aggregate, by squishing your suppliers, because they just end up with lower profits. So when you take a macro lens, it gives you a kind of framework that is coherent and consistent. And that's a really powerful style.

9:43So the Kalecki equation says, hey, look, there's a few drivers of profits. There's net investment. If you go out and you buy stuff that's going to add to productive capacity, that's going to be good for profits. It makes sense. As a corporate, you're investing in your future, but you are providing profits to somebody else. Again, we get that kind of no firm can bootstrap itself out of that situation, but it does in aggregate create profits. Dividends are another source of profits. Now, it sounds weird because we always think about dividends being paid out of profits. But dividends, of course, are an income flow to a household somewhere.

10:19And ultimately, they are therefore a form of spending or potential spending. Then you get the kind of negatives that drag on profits. So if households choose to save, that's obviously a drag. They're not spending all of their income, they're saving, that's going to drag profits down. If governments are saving, and that turns out to be kind of the opposite of what governments do, But if governments were saving, that too would be a drag. And if the foreign sector is saving, that too drags down profits. And so when I was looking back in 2012, we had pretty big fiscal deficits. Investment had fallen dramatically and effectively the government deficits had expanded to fill some of that gap.

11:03And I foolishly made the forecast that it was really the government deficits that were going to have to come down. And that was going to be the macro driver of the profit margin mean reversion that we kind of all expected. So just on that note, why did you think that government spending would come down? Because nowadays, I mean, we've had, you know, successive years of the U.S. deficit getting bigger and bigger and bigger. And it's almost taken for granted at this point that it's just going to keep growing. But why did you think that spending would actually reduce back in 2012? So I think it was it was a product of two things.

11:43So I stand there in 2012 looking at the fiscal deficit and with post GFC. And during the GFC, of course, the fiscal deficit exploded to levels that frankly we hadn't ever seen before, which are now dwarfed by what we experienced in COVID. But back then were really exceptional. And it was that kind of extremely high level of fiscal deficit over the post-GFC or the GFC, and it's kind of hangover, if you like, that really had me thinking, it's got to come down, right? Governments can't continue spending at this rate. And that was undoubtedly the thing I got wrong, because I'd simply never seen, at least in the US, fiscal deficits of such magnitude for such a period of time.

12:26I should, of course, have learned from my experiences with regard to Japan, where they'd already been running very large fiscal deficits. But at that time, I hadn't really figured out the kind of secular stagnation and the kind of is the US turning Japanese was going to be the road path. It took me a little bit longer. I began to write about that towards the end of 2012. Actually, I began to figure out that actually that was probably a more likely template. I should have actually listened to my old colleague Albert Edwards from Jen and Dress. He'd been telling me this for years. The U.S. was turning Japanese.

12:59And I was like, yeah, whatever. It was a great line. And it's the song by the Vapors. It's all cool. But I kind of just ignored him. And I really shouldn't have done because it turns out he was spot on.

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14:52As we start to move over the course of that next decade, we didn't see the big contraction in the deficit as many people expected. And then, of course, with COVID, deficits blew out again and are significantly wider than, you know, 2012 was obviously a great time in retrospect to buy stocks. And if you just bought the sort of broad stock market in the U.S. in 2012 and held to today, you would have done quite well. If we decompose the returns over that last 10 or 11 years, how much can we attribute to corporate profitability from those years, to those stock returns? So, yeah, this is a really good way of framing it.

15:32And I think the way I tend to look at it, I don't have the decom right to hand. I have done it before, actually looking at the kind of drivers. But what I found is by far and away, the most important factor turned out to be valuation rather than profits. Profits were good. They stayed high, but they did come down compared to the kind of absolute peak that we reached in 2012. So profit margins and that kind of new levels of corporate profitability, although they didn't mean revert, they didn't continue to go up. And therefore, the key driver of the performance that we've witnessed is actually being valuation.

16:08And that, I think, is, as ever, here's the prognostication for you, a cause for concern. As a value-based investor, when I see a market that is essentially being driven by multiple expansion, that makes me kind of nervous. And so, yeah, the fact that margins didn't come down, but they didn't go up from 2012, actually, they came down a little bit, and they've stayed over that decade higher than they were historically, but they didn't rise from 2012. wealth. On average, that I think tells you that the valuations have been a massive part of this problem. Just setting aside valuations for a second, I mean, if we look at some of the fundamentals in the macro economy that might have boosted profits, one of the things in your equation is dividends, as you laid out previously.

16:56And I think there are people out there who would argue that companies have gotten bigger, they've gotten more pricing power, maybe with monopolistic tendencies. Could that be genuinely boosting profitability? It's really fascinating. I think that the increase in dividends is certainly a noteworthy feature. Dividends in the last decade have indeed been significantly higher than they were over most of history. The causes of that, I think are also interesting. To me, the fact that dividends have increased really has to be combined with what happened to investment. Because I think of investment and dividends as combined as a corporate payout decision.

17:39You can either invest or you can pay dividends. At a very crude level, those are your two options. And what we've seen over the last decade compared to, let's say, the 1950s onwards, investment roughly halved and dividends roughly doubled. And so you saw this switch in payout from a world in which corporates wanted to invest to a world in which corporates chose to distribute. Now, to what extent that is driven by increasing concentration and monopolistic power, I think is an open question. And it's certainly one that I intend to return to. I did some work internally, which I haven't published yet, but it's the next one in the, or maybe - Sneak preview.

18:23Yeah, exactly. Yeah. I've written like three papers that are now in the works. There's one more after that, which is going to be the one on Monopoly, I think. And what I showed was Monopoly can redistribute profits between corporates, but doesn't actually raise the absolute level of profits terribly much, because what tends to happen is there are other offsetting factors. So I think the shift in the corporate payout policy is probably a function of monopoly. But it's not hugely surprising to me that when I combine investment and dividends and compare them over history, they haven't really, as a pair, driven this expansion of margins that we've seen.

19:04And so that fits very nicely with the work I've done, which, again, actually follows from Koletsky. He's such an amazing man and so important, and yet so few people know of him. Thank goodness the odd lot listeners are a different breed. But, you know, you walk around and they're like, why are you quoting some long-dead Polish economist? And, yeah, even worse from an American point of view, he was associated with Marx. It's like, oh, no, the end of the world is nigh. You talk to Rosa Luxemburg, this kind of thing. But he did a whole load of work on what he called the monopoly power. And it's using some of his insights that I can now demonstrate in a very simple little model that actually monopolies do not raise the aggregate level of profits.

19:51Well, let me ask you another question. And it's sort of it's another thing that I remember we and by me, we I mean, like sort of like, you know, people who are like blogging 10 years ago and trying to figure this stuff out. But another story that people told and maybe tell is that, OK, you see these profit margins at extremely high levels and that it represents some tilting of the balance between capital and labor. Labor's share of GDP has declined or unionization or labor bargaining power has weakened steadily over the years. And you could put two lines on a chart and unions are going down and profit margins are going up.

20:30Is there a zero sumness in this in terms of like how much money accrues to corporate profits versus, say, how much workers can get? Yeah, absolutely. And this was really what Kalecki, again, was talking about with his monopoly power theory, right? He was talking about exactly this issue, the distribution of the economic pie, if you like. He wrote a wonderful paper on the political aspects of full employment, all about why corporates don't actually want full employment, despite the fact that it would seem like a good idea because obviously the economy would be booming, everybody would be spending, it would be tremendous.

21:06But actually, his argument was that corporates would really not like that because it would give exactly the point you raised there, Labour too much bargaining power. And I think one of the things that people have got wrong in the whole kind of inflation story that we've heard over the last few years is the kind of permanence and that whole team transitory versus team permanent and all this kind of thing. To me, the big thing that really drives all of this is exactly the dynamic you're talking about, which is, do you have the conditions for a wage price spiral? And I have been unable to see any evidence of really significant, prolonged recapturing of Labour's bargaining power.

21:51I think that that's absolutely true. This whole dynamic is really fascinating and massively integral to understanding what we are going through, what we've been through, and potentially danger of forecasting in where we will be going. But it's to me that that distribution between labor and capital is really important. And it's tied in with monopoly. It's tied in with these kinds of issues. We're talking about the profit margins. But the really nice thing about the Kalecki equation is that it sits above all of that and it frames it all. So I've described it as like Lord of the Rings. I'm a nerd.

22:26I love Lord of the Rings. And the Kalecki equation is kind of the one ring, right? It can bring all the others and bind them in the darkness. And so having that overarching framework is really useful because it allows us to understand what's been going on with profits and therefore think about what may happen with them in the future. And what you have really is if you'd seen a huge amount of corporate power relative to labor. Normally, that would lead to wage suppression, which is deed we have seen. Wages have simply not kept up with productivity. And here I go being wrong again. In 2018, I wrote a note called Late Cycle Lament.

23:05And here we are still in a late cycle. And I used some work by another very, very insightful economist, Lance Taylor, who sadly died a couple of years ago now. He showed how we could look at wage repression and the corporates had effectively been holding wages down relative to productivity, which I thought was a very interesting take on the kind of monopoly theme, because it was, to me, less about monopoly power in the way we normally think about it and the way that perhaps is more associated with the greedflation story that we've heard more recently, which is corporates using their pricing power, but much more about what one would call monopsony, where it was more like you had a single buyer rather than a single seller of a product.

23:50In this case, it was the corporates were acting like a single buyer of labor and had squashed labor down. Now, it doesn't actually explain why over the last decade we've had high profit margins, because had they been squishing labor down, I would have expected household savings to have to decline. But by freak of accident in the sample that I looked at, it turned out that household savings have been exactly the same. Now, some of that is driven by COVID because obviously there's a huge spike in household savings during COVID. But some of it is not quite adequately represented by the average, the floor of averages, if you like.

24:28But in between these two samples, at least the 1950s to 2012 and then 2012 and afterwards, we know that household savings haven't been the big engine or be by happenstance. I don't think I wouldn't draw any conclusion by their equality in those two samples. I think they've been driven by some pretty unusual things, but we know they're not the cause of the big surge in margins that we saw. Yeah. I remember monopsony was like a big topic at, I think it was the 2018 Jackson Hole and Kalecki to some extent as well. Okay. So it makes me kind of wonder whether they're going to talk about profit-led inflation this year.

25:06But anyway, setting aside Kalecki and monopolies, which we've been talking a lot about. Can we talk a little bit more about just big government spending? Because of course, there was another very famous economist who talked about the potential for this sort of big government moment. Are we there? Absolutely. I think we are there. And you quite rightly allude to Minsky, who interestingly was a follower of Kolecki. And so there is a lovely intellectual heritage flowing through these guys. Aminsky was, yeah, absolutely a proponent of the financial instability hypothesis, which we all know and love.

25:47But also, he was a big proponent of the need for big government. And he framed big government as really a more like a job guarantee scheme, which is not what we've seen. But we have, as far as at least the data suggests, had an era where government spending has been considerably higher than anything we've seen before. And so, yeah, I think Minsky wrote a book called Can It Happen Again? And he was referring to the Great Depression. And that book is really all about making sure it doesn't happen again. And one of his takeaways was that in the event of a private sector shutdown, as there was in the Great Depression, the only thing that can happen to offset that has to be government spending.