Morningstar Q&A with Ben Inker

Inker: The behavior of corporate profits in the U.S. for the last 10 or 15 years is weird. It doesn't follow a standard capitalist script. If you've got a situation where there is a very high return on capital, which there has been on average for the last 10 or 15 years, you would expect to get a lot of investments. If the return on investment is high, capitalists go out there and invest. [If] the return on investment is low, they don't.

Well, the return on investment has been high, and yet we have been investing really quite little. There was a burst associated with the Internet bubble, but since then investment has been somewhere between a little bit anemic and, today, downright depressing. That doesn't do anything for expectations of future growth, because productivity growth really does require investment and we're not getting much investment. So, it's hard to see how we're going to get productivity growth, but profits for companies are really less about productivity growth and more about the return on capital. And if you are not getting a lot of investment, then you don't get one of the avenues towards pushing profit margins back down. Normally, higher investment would happen and that would lead to higher competition and the erosion of profit margins. So, if we're looking for reversion in profit margins, which we are, it's sort of the longer-term more subtle issues about what does it mean to have high profits in the corporate sector that is not accompanied by high investment.

When that doesn't happen, the economy can face inadequate demand. So, the corporations--if they truly are just sitting on cash--you have a problem, because nobody is spending that cash. If they do spend that cash by paying out dividends or buying back stock, the problem is that it disproportionately goes to rich people--and rich people, by and large, have a lower propensity to spend income than the rest of households.

So, even if they pay it out, it's just not clear where the demand is going to come from in the economy, and for a while that was buoyed up by spending associated with the housing boom, barring a move back into those unsustainable housing bubble condition. It's not clear how that happens. So, our best guess is that profit margins will be under pressure for the next five or 10 years, just because of the unsustainability of supporting demand without sufficient household income growth. You can see it in the resource sector where lots of people have spent a lot of money, building new iron ore plants and new capacity to get iron ore to market, that creates additional supply. And at the same level of demand, you would expect prices to fall. That's the nice straightforward microeconomic issue. What we think is going to be happening to profits is kind of more of a macroeconomic issue.

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Kinnel: Emerging markets are the brightest spot of your forecasts with a 7% real return forecast, which is interesting given that this year a lot of the news has been about a slowdown in China.

Inker: Well, we have not actually been acting as if we believed that 7% forecast. That 7% forecast is assuming everything goes back to normal, and one of the things we've been concerned about and that we have written about is the problem of China. And my colleague Edward Chancellor has been writing about it for a couple of years--that, as we see it, China has a fixed-asset investment bubble and a credit bubble and a real estate bubble. [That's] not the same thing as having a stock market bubble, but it has significant implications for not just the Chinese stock market, but for all of emerging markets. As a result, we have been more cautious on emerging markets than our forecast would suggest, and we still are.

Emerging markets have some real problems, and we are trying to figure out exactly how they will play out. We still think you've got to own some, because they are pretty cheap even if they do have some problems. And certainly having underperformed the U.S. by 27%, 28% so far this year, they are getting more attractive. I'm not sure they are quite as attractive as the forecast, which is assuming we get to go back to normal, when it isn't entirely clear what normal is for these economies.