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<< Return to Part II

In my opinion, the biggest threat to margins (and by extension, earnings) is revenue sustainability and growth potential, which faces threats on both the domestic and international fronts.

Before I get into that, let me take a second to highlight a risk which I believe is generally overlooked. Given that corporations are running so lean right now (with minimal payroll and expenses), they are more vulnerable to a dip in revenues. Normally corporations use recessions as an opportunity to trim some proverbial organizational fat: they cut non-productive and/or marginally profitable operations, they remove excess labour costs, eliminate redundancies, curtail spending, and plan/position themselves strategically for the ensuing recovery. These actions soften the blow to earnings during recessions. However, over the past several years corporations behaved quite conservatively towards expansion, meaning that they have not had a chance to reacquire very much of these expenses. As a result, any fall in revenue will flow straight to the bottom line, relatively unmitigated as there will be little in the way of viable expense-cutting alternatives.

Domestically speaking, earnings have largely been driven by margin expansion, and in turn, margin expansion can be primarily attributed to record peace-time deficit spending. With Congress split (and remaining so after the election), the ensuing dysfunction has created a lot of ambiguity regarding which direction policy will take, culminating with the impending fiscal cliff.

The fiscal cliff presents an even greater obstacle when considered in conjunction with high unemployment and underemployment. With such a large number of people unable to find work, and a similarly large number unable to find full-time work, there are a greater number of people who are dependent on these payments, and consequently, any cuts will have a more pronounced effect on their incomes.

The fiscal cliff will obviously have a large nominal effect on GDP. In its entirety, it represents ~0.6T in cuts relative to 13.62T in GDP (from the St. Louis Fed). Government spending being a component of GDP, the consensus is for a mild GDP contraction should the cuts occur as slated.

In addition to the outright effect of the cuts on GDP, one of my concerns is that it may also cause recession-like behavior in any consumers who are beneficiaries of incentives that are removed, and as I mentioned, there are a particularly large number of people reliant on these payments. The tax breaks and transfer payments that the fiscal cliff threatens to eliminate will remove money directly from the pockets of consumers. With consumer spending accounting for ~70% of GDP, and job prospects continuing to look tepid, removal of these benefits might force consumers to really hunker down and cut back on spending. What's more, I doubt that the average person fully understands what is at risk of being axed and how it would affect them personally, meaning that they won't adjust their behavior until after the fact.

Making such large fiscal cuts is a politically unpalatable course of action to begin with, so the fact that politicians are arguing about when and how to make these cuts, rather than if they should is ample evidence of the gravity of the situation. Delaying the cuts holds some appeal as it gives employment more time to pick up (which would then support incomes and corporate revenues), but even Washington now realizes that spending has to be scaled back.

Let me take a second to make an important caveat. My intention is not to argue whether or not the full effect of the fiscal cliff will come to pass. The point to understand is that even if an amicable agreement is reached, there will still be cuts made in January. These cuts will affect margins (to varying degrees depending on the nature of the cuts, but the effect will still be present). More importantly, whatever is axed in January will be the tip of the iceberg; fiscal spending must be scaled back, and taxes raised in the context of the next several years in order to rein the deficit in and prevent the debt load from spiraling out of control. As these changes are made, margins will be increasingly put at risk.

Internationally, revenues face global-growth prospects which are no longer as bright as they were a couple years ago. As two of the largest global economic regions, the most notable challenges emanate from Europe and China. With close to half of S&P 500 earnings and revenues coming from non-US sources, global economic malaise presents an obstacle for revenue growth.

As a testament to the persistence of sovereign debt problems in Europe, German Chancellor Angela Merkel recently stated that the crisis will last at least another 5 years. She warned against the assumption that problems could be resolved in 1 or 2 years. For a politician to offer such a pessimistic outlook, it speaks to size of the problem.

A lot has been said on the topic, so I won't go into much detail, but we seem to have settled into a perpetual cycle of bailouts premised upon austerity, austerity which then turns out to be counter-productive, thus exacerbating and prolonging the economic slowdown, followed by additional, larger bailout payments. Bailouts buy time to repair sovereign finances, but are not a solution by themselves. More debt isn't the solution to a problem of too much debt. Even if bailouts continue into the foreseeable future, European economic activity is on a course of gradual decline and isn't likely to reverse until the debt issues are really dealt with.

Meanwhile, China has entered an economic soft patch as well. Given that Chinese growth is heavily reliant on exports, the situation in Europe has weighed the country down and will continue to do so as long as the EU crisis lingers. Regardless of whether you fall into the hard-landing or soft-landing camp, any sort of slowdown in China is bad news for global demand. Strong growth in China was a key factor in driving the global economic recovery, but will likely be a lackluster ingredient for now.

Looking forward, international sources cannot be counted on for further revenue growth and domestic incomes face downward pressure due to fiscal spending cuts and continued un/under-employment. In spite of this, earnings forecasts for 2013 remain quite optimistic. Expectations are for 114.20 in S&P 500 operating EPS (note that S&P uses an unconventional definition for earnings, but that's a topic for another article). What kind of revenue and margins would be required to meet this estimate?

(click to enlarge)

From 2001 to 2011, S&P 500 (NYSEARCA:SPY) revenue grew at a CAGR of 3.30% (note: for the purposes of this article, I used revenue and sales interchangeably). 2012 revenue looks as though it will come in below that trend, at around 2.2-2.5% y/y depending how Q4 shapes up. In 2013, if revenues rebound and are able to grow at trend, they will come in around $1118 per share. Even so, this implies a profit margin of 10.22%, a substantial gain over 2011's 9.16% and 2012's projected 9.36%.

For the sake of comparison, if 2013 turns out to be a rough year and revenues are flat, margins will have to expand to 10.55% in order to meet EPS forecasts. This would put margins 2 full standard deviations above their 10-year average (which is already much higher than in past periods).

All of this implies that earnings forecasts are overly bullish and will have to be revised downwards over the next year.

Conclusion

The purpose of this article is not to suggest that the sky is falling or that margins will completely collapse in a matter of quarters. Rather, I wanted to draw attention to the factors which have allowed margins to expand to where they are today in order to develop a better framework for understanding where they might go tomorrow.

The result of this analysis is that due to impending fiscal adjustments (whether this happens as part of the fiscal cliff is largely irrelevant; spending must be cut and government revenue raised, as James Kostohryz points out here, and a global economy which is not as healthy as it was several years ago, I do not see a mechanism by which margins can continue to expand at the pace they have, if at all.

It is reasonable to assume that mean reversion applies to margins for the market as a whole, and margins are currently at historical highs, pointing to downside risks over the next year or two. Since earnings drive stock market valuations, and the rise in earnings has been due to margin expansion (rather than revenue growth), it stands to reason that profit margins, and the factors which affect them warrant extra scrutiny moving forward.

In particular, keep a close eye on revenue growth moving forward. By itself, one soft quarter does not mean the end of this earnings cycle. But it does demand vigilance moving forward. It may also be several quarters before the effects of any fiscal cuts become clear. This is because fiscal disbursements are made on a fairly even basis throughout the year, and because there will likely be a lag between when the cuts are made and when consumers adjust their behavior.

Source: Profit Margins: How They Got Here And Where They Are Going, Part III