US earnings season is about to get under way and corporate profit margins are bound to come under the spotlight. Margins have remained near record levels for years now, sustaining the 10-year bull market. Sceptics argue what goes up must eventually come down; are they right?
There have been some recent indications that profitability is coming under pressure. Earnings were flat in the last quarter and margins slipped slightly, with a growing number of companies pointing to increased wage pressures. Goldman Sachs has warned about mounting profit pressures, as has Morgan Stanley.
According to the latter, 54 per cent of industries experienced above-average wage growth, up from 47 per cent a year ago and an average of 42 per cent over the last 10 years, with “sustained wage pressures” a “major headwind to profitability”. Despite some slippage, margins remain above 10 per cent, way above their historical average of 6 per cent. The argument that margins would eventually revert to their historical average has been around for years, but it hasn’t happened.
Even bearish observers like GMO fund manager Jeremy Grantham, who for years preached that elevated margins were unsustainable, now concede structural forces will keep margins above levels that persisted in past decades. Similarly, while Morgan Stanley is concerned about current pricing pressures, it agrees margins are not returning to old norms, as evidenced by the fact that even during financial downturns in 2001 and 2008, profit margins among large-cap US companies remained well above the highest levels achieved over the 1974-94 period.
Nevertheless, there is serious cause for concern for long-term investors, according to Bridgewater, the world’s largest hedge fund and an influential player in financial markets. In two detailed reports earlier this year examining profit margins in the US and around the globe, the firm cautioned that margins have been rising for 25 years now and that, without this consistent expansion in profitability, US stocks would be 40 per cent lower than they are today.
"The long-term valuation of US equities hinges heavily on what happens to margins going forward”, says Bridgewater. If margins continue to expand, then valuations look reasonable; if margins stagnate, then valuations look a bit pricey but “not terrible”; if margins revert to historic norms, then US stocks are “highly overvalued”.
Pro-corporate environment
To understand where margins are headed next, one has to understand the forces that have created what Bridgewater describes as the “most pro-corporate environment in history globally”.
Lower tariffs, falling interest rates and lower tax rates – globally, corporate tax rates are now at all-time lows – are obvious factors. So too is the decline in organised labour. Globalisation has allowed major corporations to shift their operations abroad and access cheaper foreign labour, while there has been a broad-based decline in union participation rates which has extended to most European countries and Japan.
Thirdly, there has been a relaxation in antitrust enforcement, allowing for larger, more dominant firms. This has been especially so in the US but Europe has also shown a “general downward trend over the last 20 years” while enforcement has been “down to flat” in Japan.
The end result is larger and more dominant companies have emerged through mergers. Sector results in the US capture the significance of this development. Rising concentration within a sector has been linked to expanding profit margins, suggesting less competition and more bargaining power when negotiating with workers. Fourthly, the rise of larger, more dominant firms has been supported by greater scalability and “winner-takes-all” dynamics. The changing nature of the world economy has seen a shift away from tangible investments like buildings and physical equipment, and towards intangible ones like software. Large technology firms, once they secure a position of dominance, can scale up their operations without raising costs as much as smaller firms would, reinforcing their dominance and pricing power.
Turning point?
The problem for stock markets is that the global trends that have boosted profitability “are unlikely to continue being supports, and some are likely reverting”, says Bridgewater.
The potential tax arbitrage from moving abroad is much smaller, for example, while the trend towards increased profitability by moving operations to low-cost countries like China "has already started to flatten out in recent years". Meanwhile, the populist backlash against rising inequality has catalysed increased talk globally of taxing ultraprofitable firms. In different European countries, for example, policymakers have proposed a digital tax on online sales; that tech companies be restricted in how they monetise customer data; and that tech platforms be liable for liability for hate speech or, in the case of Amazon, Airbnb and eBay, be liable for collection of local taxes.
Such proposals are increasingly welcomed by voters, with surveys showing increased animosity towards globalisation and more welcoming attitudes toward government regulation of companies. These and other proposals would only have a minor impact on tech sector profitability but they are “a straw in the wind that the tide might be turning”, says Bridgewater, with the multi-decade boost from favourable taxation policies “unlikely to be repeated”. Bridgewater’s take is there is a “decent chance that we are at a major turning point for corporate margins”. If so, US equities have a “major valuation problem”.
US outperformance
The US stock market has looked much pricier than other developed markets over the last decade but it has justified seemingly hefty valuation multiples precisely because US companies have been so profitable.
Blackrock's Russ Koesterich recently noted that American large-cap companies were more profitable than non-US indices during the Noughties but the differential (1.5 percentage points, as measured by their return-on-equity) was relatively narrow. Since 2010, that spread has widened to 3.7 percentage points.
This excess US profitability has been "consistently more reliable", says Koesterich; there has not been a single month over the last decade where profitability was higher outside of the US. Microsoft, Apple and Amazon, the top three companies in the S&P 500, have an average return-on-equity (ROE) of 39 per cent. In contrast, Koesterich points out that the top three European companies – energy giant Total, German software company SAP and French luxury goods multinational LVMH – have an average ROE of 14 per cent.
The top US companies have been the primary beneficiaries of widening profit margins so it’s little wonder they have outperformed, says Koesterich. Similarly, it’s reasonable to conclude this long period of US outperformance would be endangered should margins come under pressure. Although Bridgewater warns of a near-term turning point, it admits there is “no precision” as to when and how much the various factors will weigh on profit margins. Furthermore, other factors – for example, automation – may well partly offset any decline. Even if corporate profit margins do slip in the coming quarters, the near-term implications may be limited.
According to Strategas Research Partners, markets have historically tended to rally for another year following a peak in profit margins, so a near-term deterioration in profitability need not mark the death knell for the bull market. Still, the issue is an important one for long-term investors. Markets are pricing in further expansion in margins, Bridgewater estimates, but it “will be hard for companies to maintain the current level of profitability over the coming decade, let alone increase the margins further from here”.
