QE2 has yet to begin in earnest and yet its effects are already being felt. In the words of the New York Fed’s Brian Sack, it is hoping via QE2 to (emphasis mine):
“keep longer-term interest rates lower than otherwise by reducing the aggregate amount of risk that the private markets have to bear. In particular, by purchasing longer-term securities, the Federal Reserve removes duration risk from the market, which should help to reduce the term premium that investors demand for holding longer-term securities. That effect should in turn boost other asset prices, as those investors displaced by the Fed’s purchases would likely seek to hold alternative types of securities.
In their own words the Federal Reserve is hoping that lowering interest rates and inflating asset prices will encourage business to expand and stimulate consumers due to a wealth effect. But there is a downside; in fact QE2 may already be doing more harm to the economy than good.
The Pragmatic Capitalist has been all over the Unintended Consequences of QE2. More readings also here, here and here. Essentially the argument is that by inflating input prices (commodities) the Fed is spurring margin compression as firms are not able to pass their increased costs to a weak consumer. In the roughly ten weeks since QE2 was rumored, TPC notes the following moves in commodities:
- Cotton +48%
- Sugar +48%
- Soybeans +20%
- Rice +27%
- Coffee +18%
- Oats +22%
- Copper +17%
Due to rising input prices exerting downward pressures on margins firms are less willing to expand. Any marginally lower interest expense are not likely to offset this effect as firms are not constrained by lack of access to low rate funds but by a decrease in aggregate demand and therefore an inability to raise prices.
Companies are already reporting these higher inputs costs. Just in the past week I find the following examples:
Kimberly-Clark Corp reports higher material costs. Pulp price inflation in the prior quarter was the “highest ever” according to the company.
ArcelorMittal (the world’s largest steelmaker) report costs are rising. Steelmakers faced a surge in raw-material costs even as demand for steel declined.
Kellogg Co. (the largest U.S. maker of breakfast cereal) lowered its forecast. They are facing rising commodity prices, specifically corn and sugar. They will be attempting to raise prices on about 25% of its cereals due to these rising input prices.
With commodity prices rising and companies already warning of these higher costs it is instructive to looks at current corporate profit margin levels as they have been a leading contribution to the recovery to date.
First we will look at the profit margin on the S&P 500. Note the recovery in margin to within 1.4% of the 2007 peak and above both the 10 year average and median.
For a longer-term view we examine corporate profits as a % of GDP. Since 1947 corporate profits have averaged 6.0% of GDP with a standard deviation of 1.5%. The current level of 9.5% is 2.4 standard deviations above average; higher than any other period except Q4 1950 and from Q1 2005 to Q4 2006.
Another way to view this long term trend is by regressing S&P 500 earnings on nominal GDP. The long-term trend in GDP growth has been fairly stable and as can be seen in the chart, earnings tend to oscillate around this long-term GDP growth rate. This is the method used by Crestmont Research.
As can be seen on all three charts, corporate profits are above both recent and historical averages. This will be something I follow going forward with 2010 Q3 advance GDP due Friday.
Even without the effects of margin compression due to higher commodity prices, we would expect a decline in margins at some point due to increased competition and new entrants. Higher asset prices via QE2 may only speed the process.