December 4, 2022

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Divided Government, Diminished Profits | financial times

5 min read

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Good morning fed day. Yesterday’s Jolts data showing that job vacancies are rising again will not have put the FOMC in a good mood. But a rate hike of 75 basis points was committed anyway. The market expects Jay Powell to utter a vague phrase suggesting that the next move will be 50 basis points in December and that a pause in hikes is on the horizon. If that doesn’t happen, we expect markets to take it hard. Email us: and

The midterms will be bad news for investors

Republicans will most likely take control of the House of Representatives next week. This is not an elaborate political forecast on the part of Unhedged. It’s just that Democrats now control 220 seats to Republicans’ 212, with three vacant seats, two formerly Democrat and one Republican. Call it a nine-seat rand. When the Dems lose a five-seat net, control shifts. Since 1934, the president’s party has lost an average of 28 seats in midterm elections, according to the American Presidency Project. Joe Biden also has a clearly negative net approval rating. Inflation makes everyone angry. The FiveThirtyEight election model, for example, puts the probability of a change of power at four to five.

What’s at stake for investors? To exaggerate slightly, this:

This is the annualized rate of after-tax earnings for US companies. You may notice a small break in the trend from where the pandemic started. Corporate profits have increased by a third. Where did that extra $1 trillion or something come from? Much of it came from here (data from Ed Mills at Raymond James):

Divided Government, Diminished Profits |  financial times

Government spending, particularly debt-financed government spending, has stalled since the pandemic began. And as we mentioned earlier, deficit spending and corporate earnings are closely linked. The Levy-Kalecki equation (a basic accounting identity) states that profits are a residual equal to investment minus household, government and foreign savings (i.e. the current account deficit). That makes intuitive sense. Savings are funds received but not spent. To make a profit, companies must get US households, the US government, and foreigners to spend, not save.

It is particularly clear why government deficit spending, which has exploded during the pandemic, would be closely linked to profits. When the government borrows and spends money, the money goes to corporations either directly (think a defense contractor) or indirectly (think a stimulus check used to buy a new TV). Yes, as government deficits shrink, there are several ways US books could be balanced — households and foreigners, for example, could go on a spending spree to replace lost government generosity. However, a drop in profits seems more likely to us.

If we get a divided government, deficit spending will fall even more steeply than it already is because no major spending bills will be passed, even in the “reconciliation process” that Democrats have relied on for the past two years. As BTIG’s Isaac Boltansky puts it, “The only time deficit hawks fly in Washington DC is under a divided government.” And this partisan austerity policy will very likely come at the expense of profits. The timing of the decline and how it will be spread across industries is uncertain; the direction of the trend is not.

However, investors can take comfort in the fact that two years from now, one party or another could control the presidency, House of Representatives and Senate. When that happens, the borrowed money will flow again, with certainty from day to night.

Uber isn’t really a tech company

Uber reported solid third-quarter results yesterday. The highlights: more drivers than before the pandemic, better-than-expected revenue growth and the second consecutive quarter of positive free cash flow.

Uber's quarterly free cash flow* line chart shows much better

The markets liked it. Uber shares rose 12 percent. But like many recent startups that have gone public, the stock’s one-year chart remains ugly. The Economist senses a theme:

Last year, the companies that embody them [new tech] Business Models – Uber and DoorDash; Netflix and Spotify; and Snap and Meta (which have spectacularly fallen out of the trillion-dollar club) – have lost two-thirds of their market caps on average…

Their businesses all face the same key pitfalls: a misguided reliance on network effects, low barriers to entry, and a dependency on someone else’s platform…

Network effects are real. But they also have their limits. Uber believed its lead in ride-hailing would buy it a ticket to riches, as more riders and drivers would mean less idle time for both, drawing more and more users into an unstoppable maelstrom. Instead, it encountered diminishing economies of scale: reducing average wait times from two minutes to one minute would require twice as many drivers, although most drivers would hardly notice the difference.

We would put it differently. The problem is not the limits of network effects, but that network effects are not enough. The companies that have reaped huge profits from network effects had something else to offer: low incremental unit costs. The next search ad Google posts, the next software Microsoft sells, the next Amazon Web Services-hosted workload costs these companies next to nothing, or at least far less than the one before.

Uber’s unit cost will never go down as fast as other companies because it’s a taxi company. It charges consumers for trips, pays most of that money to drivers and car insurers, and collects a cut (about a fifth of fares). The much-vaunted grocery delivery business is a little different: calculate delivery costs, pay most of it to drivers and restaurants, and take a cut. Technically, Uber doesn’t own the cars in its fleet, but ultimately it has to pay for their depreciation by fairly compensating its drivers. In that sense, it also pays off for the petrol burned on each trip. And of course the first driver has to be paid the same as the last one. Uber has the economics of an asset-intensive company because it actually is one.

This is neither new nor bad in itself. Uber has some economies of scale. Because it’s the largest ridesharing app, the company covers more territories and has shorter wait times than Lyft, its only true US competitor. That attracts more riders, which in turn attracts more riders. Uber is therefore in a stronger position than Lyft. But whether there is one driver or 1 million, Uber has to pay drivers 70-80 cents on the dollar. Scaling can help with some expenses – building the app always costs the same no matter the number of users – but nothing like a Google or a Microsoft.

Over the trailing 12 months, Uber’s free cash flow margin was 2 percent. Even if you extrapolate this quarter’s excellent results for the year, the figure rises to just 4 percent. Sounds about right for a taxi company. Google’s free cash flow margin? Twenty two percent. (Wu & Armstrong)

A good read

In one form or another, almost all web advertising goes through the conduits of Google. It has an internal ad tech system called, no joke, the Borg. Resistance is futile.

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