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Parnassus Digest - January 2013

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2013 Economic Outlook: Sectoral Financial Balances

The sustainability of the U.S. deficit has become a widely debated issue. Most of the discussions have considered the budget deficit in isolation, ignoring the fact that the government is an integral part of the economy, interacting with households, businesses and foreign trading partners. In this Parnassus Digest, Portfolio Manager of the Parnassus Fixed-Income Fund, Minh T. Bui, discusses the link between the U.S. government budget and the rest of the economy and how changes in the government budget can impact other economic sectors.

A useful tool to understand the connection between the government budget and the economy is the sectoral financial balance framework, developed by the late British economist Wynne Godley. This framework is advantageous because it is based on an accounting identity rather than theory. An accounting identity is an equality that must be true regardless of the value of its variables.

The starting point of this framework is that one person’s spending is always another person’s income. This implies that during any accounting period, total spending must equal total income for the economy as a whole. However, this equality does not hold true for individual sectors of the economy, as any one sector can have a surplus, a deficit, or a balanced budget.

A budget surplus means that a sector is spending less than its income and it is using the difference to increase savings or pay down debt. In contrast, a budget deficit indicates that a sector is spending more than its income by running down its cash balances or by borrowing more.

The important point is that the sum of all sectors’ financial balances must equal zero. Therefore, if we divide the U.S. economy into three sectors to include the private sector (households and businesses), the government sector, and the foreign trade sector, then the following identity must hold true:

U.S. Private Sector Balance + U.S. Government Balance + Foreign Sector Balance = 0

When the foreign sector runs a budget surplus with the U.S., this means that foreigners are selling more exports than they are buying in imports. From the U.S. perspective, we are importing more goods and services than we are exporting, which implies that the U.S. current account is in deficit. Therefore, the foreign sector balance is equivalent to the inverse of the current account. Substituting the current account balance (the difference between exports and imports) for the foreign sector balance results in the following equation:

U.S. Private Sector Balance + U.S. Government Balance – Current Account Balance = 0

This sectoral financial balance equation shows that it is impossible for all three sectors to run a financial surplus at the same time. Since the sectoral balances must sum to zero, if one sector runs a deficit, at least one other sector must run a surplus. For example, if the government sector runs a budget deficit, then the combined private and current account balances must add up to a surplus of equivalent size.

Exhibit 1 shows the U.S. sectoral financial balances since 1960. As of the third quarter of 2012, the U.S. private sector ran a surplus of 5.9% of GDP, the U.S. government had a deficit of 8.6% of GDP, and the U.S. current account deficit stood at 2.7% of GDP. Using the equation above, the sum of all three sector financial balances equals zero: +5.9% + (-8.6%) - (-2.7%) = 0.

It’s important to note that it is not possible to determine from the equation what causes a particular sector’s balance. For example, we cannot know if the fiscal deficit is driving the surpluses in other sectors, or if the surpluses in the other sectors are driving the fiscal deficit. Unfortunately, the accounting identity does not say anything about the direction of causation. It also does not inform us about the sustainability of the debt increases necessary to finance any deficits, or if spending is directed toward productive assets.

Regardless of the direction of causation, the recent political efforts to rein in government spending suggest a lower government deficit is on the horizon. As we now know, by identity, the government deficit cannot be reduced without a decline in either the private sector surplus or the current account deficit.

Unless the U.S. dollar significantly devalues, thereby making U.S. exports cheaper for our trading partners, the U.S. will likely continue to run a current account deficit by importing more than it exports. This leaves the private sector (household and business sectors) to do much of the adjustments to offset a lower government deficit.

Since the household sector is still saddled with excessive debt accumulated during the housing market bubble, it will probably continue to prioritize paying down debt and increase savings. Moreover, the household sector’s spending growth is likely to be slower than income growth due to stagnant wages and tepid employment growth. In other words, the surplus in the household sector should remain high, similar to its historical levels (green line in Exhibit 2).

This means that the surplus in the business sector (red line in Exhibit 2), rather than the household sector surplus, will most likely shrink. The current high business sector surplus mainly reflects weak capital expenditures that have not kept pace with profit and cash flow growth in recent years. This high surplus has also provided a boost to U.S. corporate profits. As shown in Exhibit 3, the current ratio of corporate profits to GDP stands at 9.7%, which is much higher than its historical norm. Therefore, I think that the business sector surplus will decline essentially through lower income, which means that corporate profits will come down from the current levels.

In sum, the financial balances framework shows that changes in government deficits, or in any other financial balances, will force adjustments somewhere else in the economy. In the U.S., I argue that the adjustments to a lower government deficit will most likely impact the corporate sector through reduced earnings. I am not advocating for or against a large government deficit. Instead, I am simply stating that changes in the government deficit should not be considered in isolation. In my opinion, the combined efforts of both the government and the household sectors to reduce their debt levels and/or deficits will lead to deteriorating corporate profits. Furthermore, I think that this potential downside risk is currently not discounted in the financial markets for many risky assets, and should be taken into consideration when making investment decisions.

The views expressed in this Parnassus Digest are subject to change at any time in response to changing circumstances in the markets and are not intended to predict or guarantee the future performance of any individual security, market sector or the markets generally, or the Parnassus Funds. Any specific securities discussed may or may not be current or future holdings of the Funds.

Total % Returns as of 12/31/2012
3 Mo. YTD 1 Yr. 3 Yr. 5 Yr. 10 Yr. Since
Inceptiona
Expense Ratio
Grossb Netb
Parnassus Fund 3.77 26.04 26.04 11.80 6.37 7.41 9.44 0.94 0.94
S&P 500 Index (0.38) 16.00 16.00 10.86 1.66 7.09 10.56 NA NA
Parnassus Equity Income Fund
Investor Shares
1.20 15.43 15.43 9.03 5.15 8.12 9.85 0.94 0.94
S&P 500 Index (0.38) 16.00 16.00 10.86 1.66 7.09 8.39 NA NA
Parnassus Equity Income Fund
Institutional Shares
1.25 15.64 15.64 9.26 5.38 8.27 7.27 0.70 0.70
S&P 500 Index (0.38) 16.00 16.00 10.86 1.66 7.09 3.47 NA NA
Parnassus Mid-Cap Fund 2.52 18.58 18.58 13.30 6.95 NA 7.19 1.24 1.20
Russell Midcap Index 2.88 17.28 17.28 13.15 3.57 NA 7.09 NA NA
Parnassus Small-Cap Fund 5.01 18.40 18.40 12.14 8.53 NA 8.35 1.22 1.20
Russell 2000 Index 1.85 16.35 16.35 12.25 3.56 NA 6.53 NA NA
Parnassus Workplace Fund 2.03 22.03 22.03 10.69 9.02 NA 8.99 1.16 1.16
S&P 500 Index (0.38) 16.00 16.00 10.86 1.66 NA 4.95 NA NA
Parnassus Fixed-Income Fund (0.25) 2.08 2.08 5.28 5.25 4.93 5.90 0.81 0.75
Barclays Capital U.S. Govt/Credit Bond Index 0.37 4.82 4.82 6.70 6.06 5.24 6.38 NA NA

All returns greater than one year are annualized.

a The inception date for the Parnassus Fund is December 31, 1984. The inception date for the Parnassus Equity Income Fund and Parnassus Fixed-Income Fund is August 31, 1992. The inception date for the Parnassus Mid-Cap Fund, Parnassus Small-Cap Fund and Parnassus Workplace Fund is April 29, 2005. The inception date for the Institutional Shares of the Parnassus Equity Income Fund is April 28, 2006.

b As described in the Funds’ current prospectus dated May 1, 2012, Parnassus Investments has contractually agreed to limit the total operating expenses (exclusive of acquired fund fees and expenses) to 0.99%, 0.99%, 0.78%, 1.20%, 1.20%, 1.20% and 0.75% of the net assets of the Parnassus Fund, the Parnassus Equity Income Fund-Investor Shares, the Parnassus Equity Income Fund-Institutional Shares, the Parnassus Mid-Cap Fund, the Parnassus Small-Cap Fund, the Parnassus Workplace Fund, and the Parnassus Fixed-Income Fund, respectively. These limitations continue until May 1, 2013, and may be continued indefinitely by the Adviser on a year-to-year basis. Without these fee waivers and/or expense reimbursements, the Funds’ returns would have been lower.

Performance shown for the Parnassus Equity Income Fund – Institutional Shares prior to the inception date of April 28, 2006 reflects the performance of the Parnassus Equity Income Fund-Investor Shares and includes expenses that are not applicable to and are higher than those of the Institutional Shares.

Performance data quoted represent past performance and are no guarantee of future returns. Current performance may be lower or higher than the performance data quoted, and the most recent month-end performance is available on the Parnassus website (www.parnassus.com). Investment return and principal will fluctuate, so that an investor’s shares, when redeemed, may be worth more or less than their original principal cost. The S&P 500 Index, the Russell Midcap Index, and the Russell 2000 Index are widely recognized indexes of common stock prices. The Barclays Capital U.S. Government/Credit Bond Index is a widely recognized index of fixed-income security prices. An individual cannot invest directly in an index. An index reflects no deductions for fees, expenses or taxes. Returns shown for the Funds do not reflect the declaration of taxes a shareholder would pay on the fund distributions or the redemption of fund shares. Prior to March 31, 1998, the Parnassus Equity Income Fund was a balanced fund. Prior to May 1, 2004, the Parnassus Fund charged a sales load of a maximum of 3.5%, which is not reflected in the total return figures.

Common stock prices fluctuate based on changes to a company’s financial condition and on overall market and economic conditions. Small- and mid-cap companies can be particularly sensitive to changing economic conditions and have fewer financial resources than large-cap companies. Investments in fixed-income securities are subject to interest rate risk, credit risk and market risk, each of which could have a negative impact on the value of the Fund’s holdings.

The Parnassus Funds are underwritten and distributed by Parnassus Funds Distributor, a subsidiary of Parnassus Investments and a FINRA member.

Before investing, an investor should carefully consider the investment objectives, risks, charges and expenses of the fund and should carefully read the prospectus or summary prospectus, which contains this information. A prospectus or summary prospectus can be obtained on the website, www.parnassus.com, or by calling (800) 999-3505.