How the flow of funds in the economy effects corporate profits

Throughout the global economy, every time someone (or some entity) receives a cash inflow, someone else (or some other entity) is paying a cash outflow.

When you receive money in your bank account, some person or entity has got a little bit poorer by paying that money to you, and when you buy something from a business, that business’s bank account gets a little bit richer as a result of receiving that money from you.

Similarly, when governments spend money (for example, paying the salaries of teachers or police officers) the household sector receives a cash inflow, but the government is incurring a cash outflow, which adds to its overall sum of monetary obligations to the private sector.

Understanding the flows of money between different sectors of the economy can help us to understand the source of profits across the corporate sector. In the diagram below, I show most of the key ways in which money flows around the economy.

I leave the banking sector out of this diagram. Of course, in one sense most of the cashflows shown in the diagram above are just from the banking sector to the banking sector. But overall, the banking sector’s net monetary balance with the rest of the economy stays pretty close to zero. In other words, the total value of borrowings by the global banking sector (including customer deposits) is approximately equal to the total value of lending by the banking sector (including loans to governments and monies on deposit with central banks).

The diagram essentially shows how each sector’s net financial balance with the banking sector is affected by different types of transactions. From this perspective it does not matter whether the individual paying the cash is funding it by paying money out of a bank account with a positive balance or is funding the cashflow out of borrowings (e.g. credit card purchases). For example, the net financial balance of the household sector goes down and the net financial balance of the business sector goes up when households engage in consumer spending, regardless of how households fund that spending.

A key point to recognise with this diagram is that each sector of the economy is both paying money and receiving money from each of the other sectors.

As all these flows add up to zero, the extent by which any one sector can achieve a surplus depends on the net flows between it and the other sectors.

For example, if households are trying to increase their annual savings, they will likely cut their level of consumer spending. This would in turn negatively impact the net cashflows for businesses, as business profits clearly benefit when consumer spending is high relative to the wages & salaries that businesses pay to households.

 Bottom-Up vs Top-Down

The diagram above gives us a “top-down” perspective on what drives corporate profitability. Later in this column, I’m going to look at what this “top-down” perspective tells us about what is currently driving corporate profitability, and look at what insights this may give us about the outlook for (and risks to) corporate profitability.

As investors in listed companies, we are used to normally looking at companies from a “bottom-up” perspective. This typically involves forecasting a company’s revenues on the basis of projected trends in demand for the type of product that it produces combined with our expectations for changes in its market share to forecast its revenue. We can then forecast company profits by starting with our revenue forecast and thinking about how the company’s profit margins will be affected by factors such as its growth in revenues, changes in the competitive environment, and any cost pressures affecting the inputs that it uses to produce its products.

This bottom-up perspective is hugely important, but focussing entirely on the bottom-up can lead to a sort of myopia, whereby equity investors inspect each seedling in a forest, and individually forecast a huge number of them to grow into mighty trees, without stopping to think about whether there will be enough water and space and sunlight in the forest to support all of these huge trees.

You can routinely observe this dichotomy with the equity research teams of large broking firms, whereby you can add up their analysts’ forecasts for most of the companies in the share market, and derive a forecast for (say) 12% growth in aggregate market earnings, whereas the strategists and economists are sitting in the corner forecasting that total earnings of the market will only grow by (say) 4%. More often than not, it is the strategists/economists that are closer to mark for aggregate profit growth, even if the analysts do a pretty good job at picking which individual companies will grow the fastest.   

Hence, we continue to forecast profits at an individual company level, but try to also remain aware of the bigger picture, thinking about how aggregate profitability is affected by the flow of cash between various sectors of the economy.

How does the money keep flowing?

If you think about the position of each of the sectors shown in the diagram above, it is easy to understand how an economy can go into a slump if each sector is trying to improve its balance sheet.

To understand this, we’ll review each sector individually:

Government

Let’s look first at the position of governments, shown in the snip from our diagram below. Governments collect taxes from households and businesses and spend money by making payments in the form of salaries and welfare benefits to households, purchases of goods & services from businesses, as well as the payment of interest on government debt. If governments are trying to run fiscal surpluses, they will do this by either cutting spending or raising taxes. Either way, fiscal restraint will negatively impact cashflows for both the household and business sectors.

 Households

Now let’s look at the position of the household sector (shown in the snip below). The household sector receives wages & salaries from governments and businesses, as well as getting welfare benefits from governments, and drawing on their own savings in retirement.  

Most people try to live within their means, which means that prior to retirement they’ll aim to keep their consumer spending below the level that they can fund from wages, salaries, and welfare benefits. This tends to mean that if the flow of wages, salaries, and welfare benefits to households reduces, consumer spending will reduce commensurately.

For many households (particularly those on lower incomes) this relationship can be almost one-for-one. If their income drops by $1, their consumption spending will also drop by almost $1. As a consequence, we never see corporate earnings booms driven by cost-cutting. While a single company may improve profitability by cutting costs (e.g. by reducing staff numbers or spending less with other businesses), when all businesses try to do it, it boomerangs back and reduces the aggregate revenues of the business sector.

The tendency of households to try to spend less than they earn seemingly conflicts with the ambitions of the business sector, which wants to generate profits by getting more revenue from selling stuff to households than the expenses that it pays in the form of wages and salaries to households. In a predominantly capitalist economy, how can households and businesses simultaneously achieve their desired surpluses?

Pay attention to the arrow labelled “Buying new homes” in the diagram above. This is a form of household spending that is not typically funded out of current incomes. Rather, households consider that they’re acquiring an asset when they buy a new home, and will therefore willingly borrow to spend a lot more money on a home than they can fund out of current income.

When a lot of new homes are being built, households will therefore spend significantly more money than they are receiving in current income. This tends to happen when the population is growing, the labour market is strong, and house prices are high. When lots of homes are being built, households think they’re saving, businesses think they’re making profits, and everyone is happy.

Businesses

We’ll now focus on the position of businesses. The cashflows for the business sector are shown in the diagram below.

Of course, businesses spend a lot of money buying materials, goods, and services from each other. However, (with the exception of capital expenditure) we don’t show this in the diagram below, because at the aggregate “business sector” level, business-to-business spending nets out to zero.   

In aggregate, businesses get revenue from consumer spending, government purchases of goods and services, and household purchases of new homes. They spend money on paying wages and salaries to employees and paying taxes. The difference between these sources of income and expenditure represents the free cashflow of the business sector, much of which will ultimately be paid out in the form of dividends to shareholders.

(Most businesses are predominantly (but indirectly) owned by households, which means that dividend income also flows to the household sector. However, most dividend income either flows into retirement savings accounts, or to the bank accounts of high net worth individuals, and there is a much lower propensity to consume out of either of these income flows than is the case with salaries flowing into the bank accounts of people with about-average incomes.)

 

Looking at the interactions between the business sector and the government sector, it should be easy to understand how fiscal policy affects corporate profitability. If governments are spending more than they earn, it is likely that businesses will also be receiving more money from governments than they’re paying in taxes, hence contributing to corporate profitability.

Similarly, when we look at the interactions between businesses and the household sector, we can see how household decisions about saving vs spending impact corporate profitability. Businesses try to make profits by selling stuff to consumers while paying wages and salaries to their employees. Households get most of their income from wages and salaries paid by businesses, and they spend most of this income on the stuff that businesses sell. So, if households collectively decide that it’s a good idea to save more money, this will inevitably have a negative impact on business profitability. This is why consumer confidence can be such an important driver of corporate profits. If consumers are confident about the future, they’re going to be less worried about spending most of their current income.

Finally, I want to draw your attention to the arrow labelled “capital expenditure”, which shows the effect of businesses engaging in capital expenditure. Because business capital expenditures almost always involve a flow of funds from one business to another, they do not directly affect the flow of funds in and out of the business sector.

However, capital expenditures are vitally important to reported profitability, because the business making the expenditure records capital expenditure on the “capital account” (affecting the balance sheet but not the income statement), whereas the business that is providing the equipment that the money is being spent on is generally recording this as revenue.

For example, Microsoft and Alphabet are currently spending record amounts on capital expenditures, largely in the form of the construction of data centres and purchase of AI servers, but because they record this as capital expenditure, it does not affect their income statements. On the other hand, companies like Nvidia, Broadcom, Taiwan Semiconductor and Super Micro Computer are getting a lot of revenue from supplying the semiconductors and servers that will run in Microsoft and Alphabet’s data centres, and they are recording this in their income statement as revenue. Net-net, this spending by Microsoft and Alphabet will have caused a slight net cash outflow for the business sector in aggregate, but it has led to a massive increase in aggregate profitability, as Nvidia is recording 60%+ profit margins on the sale of AI chips.  

How does this all relate to the current environment?

Up to the most recent paragraph, I’d talked about how the various sectors of the economy interact in very abstract terms, without trying to relate this to the current environment. Let’s now see if we can apply this model to the current environment to help understand what is currently driving corporate profits, and to see if we can draw inferences about how the future may unfold.

A key thing that any equity investor should try to understand is why corporate profits are currently so high by historical standards, particularly in the United States. The graph below shows the ratio of corporate profits to GDP in the United States over the past 76 years. As you can see, corporate profits rose to record levels in 2010 and have stayed at those elevated levels ever since.

So what happened in 2010?

Most obviously, government fiscal deficits expanded as governments around the world undertook fiscal stimulation and bail-out measures to deal with the effects of the 2007-2009 global financial crisis. Initially, the stimulatory effect of these fiscal measures was offset by a decline in capital spending, but by 2010 capital spending was recovering, but fiscal stimulus remained strong, as you can see (for the United States) in the graph below:

While governments initially began to transition back towards fiscal sustainability as the effects of the GFC receded, the US changed fiscal course after Trump was elected in 2016 and cut corporate taxes. Then when Covid-19 hit in 2020, governments began to spend money like never before, resulting in even larger fiscal deficits than we’d seen after the GFC.

Capital spending

As we discussed earlier in this column, elevated capital spending can also boost reported profits.

This includes both:

• Capital spending by households (i.e. purchase of newly-constructed homes), as households don’t feel the need to fund purchases of homes out of current income (in the way that they would with most consumption spending); and
• Capital expenditures by businesses, where money flows from business to business, where the business spending the money doesn’t deduct the cost from its calculation of profits, but the business receiving the money counts it as revenue.

Looking first at spending on new residential housing, I can only find a consistent time series for the United States going back 22 years (see graph below). This shows that spending on new homes is higher than it’s been for most of the post-GFC period, but is not as high as the inflated levels that it got to prior to the global financial crisis. But looking at partial indicators like building permit statistics, it does not seem like residential building activity is particularly high relative to long term averages.

 We can however get longer term statistics for aggregate private sector capital expenditures (combining both home-building and business capital expenditures) going back to 1948. This aggregate capital spending is shown in the graph below. As can be seen, aggregate capital spending is currently at levels that are slightly higher than the historical average (therefore contributing towards slightly higher profitability), but is by no means at the historically unprecedented levels that we’ve been seeing for the US fiscal deficit over the past 16 years.

In summary, I think the data shows that loose US fiscal policy is a key contributor to the currently elevated level of US corporate profits. Slightly higher-than-average levels of capital spending are also contributing, but do not explain much of the lift between historical levels of profitability and the elevated levels we’re seeing today.  

What does this tell us about the outlook?

Anyone with a modest level of spreadsheet proficiency should be able to work out that fiscal deficits of over 7% of GDP cannot be sustained indefinitely in an economy that is likely to grow about 4% per annum over the longer term. High deficits will result in debt growing faster than GDP, which would in turn lead to the government’s interest expense growing faster than the tax base, which will ultimately become unsustainable, and could lead to a loss of confidence in the value of the US dollar.

This ugly maths does not mean that politicians will necessarily do anything to reduce the deficit in the next few years, as the issue could still be kicked down the road for another decade or two before it becomes critical. In fact, Donald Trump is promising a further corporate tax cut, which could potentially boost the already-elevated US profit/GDP ratio.

But equity investment is for the long-term, particularly while investors in the US equity market are only getting a dividend yield of 1.3%, so it is only sensible that we think about where the US corporate profit/GDP ratio is likely to trend over the next two decades. In my view, the high levels of US corporate profitability combined with the fact that this is tied to an ultimately unsustainable US fiscal deficit indicate that the balance of probabilities is that the US corporate profit / GDP ratio will decline over the next two decades.

While I have mentioned that current levels of residential building activity are not particularly high by historical standards, I would caution that this observation needs to be interpreted in the context of slowing population growth rates. The US population grew at 1.4% per annum between 1934 and 1974, grew at 1.0% per annum between 1974 and 2014, and has only grown at 0.56% per annum over the last decade. With the US fertility rate having fallen well below replacement rates (at 1.66 births per women) and net migration only contributing about 0.3% to population growth each year, it is likely that population growth rates will continue to fall. With slowing population growth, it is hard to see demand for more than the 1.4 million homes that are currently being built each year.

 

Nicholas Bagnall is Chief Investment Officer of Te Ahumairangi Investment Management

Disclaimer: This article is for informational purposes only and is not, nor should be construed as, investment advice for any person. The writer is a director and shareholder of Te Ahumairangi Investment Management Limited, and an investor in the Te Ahumairangi Global Equity Fund. Te Ahumairangi manages client portfolios (including the Te Ahumairangi Global Equity Fund) that invest in global equity markets. These portfolios include investments in Microsoft and Alphabet which were mentioned in this article.