Stock market investors should exercise caution when wishing for the so-called Department of Government Efficiency, or “DOGE,” to significantly lower the U.S. budget deficit.
This is due to the fact that the profit margins of firms and the budget deficit’s percentage of the US GDP are closely related. The corporate profit margin will most likely drop significantly in tandem with a significant reduction in the government deficit.
Given that the last bull market was primarily based on growing profit margins, that might be extremely pessimistic. If its operating profit margin were no higher than its trailing 30-year average (7.37%), rather than its projected 2024 level of 11.88% (fourth-quarter 2024 results are not yet confirmed), the S&P 500 SPX would have to decline 38%, holding all else equal.
If you doubt that corporate profit margins and federal budget deficits are related, look at the preceding chart. The operating profit margin of the S&P 500 and the percentage of GDP that goes to the U.S. budget deficit are plotted year over year. There is a clear association.
A recent study from Vincent Deluard, global macro strategist at StoneX Group, reminded me of this connection. However, he emphasized in an email that the late Polish economist Michal Kalecki, well renowned for his work on the relationship between public deficits and private profits, deserves the credit for finding the association.
“Public accounting requires that the public sector’s deficit equals the private sector’s surplus,” explains Deluard. Because the U.S. government continued to run a deficit of 7% of GDP four years after the pandemic ended, private companies and employees eventually cash the check when the government spends trillions of dollars on green infrastructure, data centers, or vaccines. As a result, U.S. growth and profit margins have been abnormally high.
Inefficient government expenditure
What if DOGE’s proposed cuts to government spending turn out to be ineffective and wasteful? That must be advantageous for business earnings in particular and the economy as a whole.
Deluard concurs, but he issues a warning that the short-term negative effect on company earnings is temporary, while the long-term economic benefits of reducing unnecessary government spending become apparent.
“The private sector will likely benefit from the release of these resources [from cutting unnecessary spending], but short-term growth will undoubtedly suffer. The GDP and private profits both rise when government employees are paid to dig and fill holes at night, and vice versa.
Reducing unnecessary government expenditures is a noble objective. Investors, however, should not ignore the connection between corporate profits and state deficits. For example, Deluard predicts that U.S. stocks will experience a bear market later this year.
