Despite persistent economic weakness, one sector of the economy continues to perform well: Corporations.
One sign of how well a company is performing is its profit margin – a measurement of how much of each dollar of sales a firm retains in its earnings and how well that company controls its costs. Today, corporate profit margins are near record highs.
But as concerns of a double-dip recession persist, many market watchers are wondering how much longer high profit margins can last. Answers to this question often focus solely on expectations for rising input prices. But I agree with the major conclusion of a new BlackRock Investment Institute paper — profit margin sustainability is more related to overall economic activity than it is to input costs alone.
Viewing profit margins from this angle, how long can high profit margins be sustained?
The Institute’s paper, “Can Investors Continue to Profit from Corporate Margins,” argues that it is unlikely that corporate margins will move back down to their long-term average level within the next three years or so. After that, margins are likely to revert back to their long-term average as the forces that have kept them high start to unwind.
I agree that margins will likely remain high in the near term. Why? Thanks to the silver linings of today’s slow-growth environment.
It’s true that slow economic growth hurts top-line growth (think revenues). But there are many factors currently holding down input costs — low wages; falling prices for industrial commodities like oil and copper; and a negligible cost of capital due to low interest rates. These benefits should help sustain corporate profitability for at least the next couple of years, assuming the economy does not fall back into another recession (a scenario I don’t think is likely to happen)
As these silver linings fade, so too should elevated profit margins. As the economy recovers over the next two to four years, input costs such as the cost of capital will rise along with interest rates and (arguably) commodity prices.
Over the next two years, I also expect that wage costs will rise slowly, but steadily, in emerging manufacturing centers such as China. When the economy recovers, workers in the US will also begin to ask for raises. These higher costs will cut into margins.
I also expect revenue growth to slow further. How could that happen in a recovering economy? At some point, the government is going to need solve its long-term fiscal problems. When that happens, we’ll see lower government and consumer spending. Personal consumption, which has been partly funded by cheap credit and government transfer payments, will slow, hurting profit margins.
What does this mean for investors? The major implication is that margins appear to be sustainable in the intermediate term, assuming no double-dip recession occurs. To the extent that margins hold up, equity valuations appear cheap. However, as the Institute paper mentions, if for some reason corporate margins were to compress sooner than expected, valuations would be less compelling.