Why corporate profits are at historic levels and what to do when they shrink
In an economy with few bright spots, the corporate sector has remained remarkably resilient and unusually profitable. U.S. corporations are generally flush with cash and have managed to maintain historically high margins despite anemic growth and a lack of consumer confidence.
But how long can this continue? An unusual combination of low inflation, low interest rates, and just enough growth can probably sustain margins over the near term. The principal risks to corporate profitability are likely to come from either too little growth - the global economy slips back toward recession - or, ironically, a surge in growth that leads to higher interest rates, higher input prices, and higher wages. To the extent the global economy continues to muddle along, this may actually extend this unusual period of high corporate profitability.
Eventually, however, this benevolent combination will come to an end. When that occurs, how should investors position their portfolios? The answer depends on why margins are shrinking:
- If margins compress due to a stalling economy, investors should do well to follow their instincts and get defensive. Historically, classic defensive sectors such as consumer staples, healthcare, and utilities have been the most resilient to margin compression due to a weak economy.
- If the economy continues to rebound and ultimately inflation rather than growth is the culprit, investors may want to adopt a different approach, favoring natural resource companies that can benefit from rising prices.
In either case, investors may want to remain cautious on financials. While the sector appears cheap, unless one expects a return to a Goldilocks economy - strong growth and falling interest rates - this sector is vulnerable to both a stalling economy and rising rates.
Corporate America: Last Man Standing
Adversity has the effect of eliciting talents, which in prosperous circumstances would have lain dormant.
The 13th annual Global Automotive Executive Survey, conducted by KPMG and released on January 5, indicated that U.S. auto brands should continue to increase market share over the next five years. The report went on to conclude, "Global executives see the American resurgence spurred by product innovation, continued improvement in product quality and restructuring activities." This is a remarkable statement about an industry that less than four years ago faced an existential crisis, necessitating a federal bailout. It is also illustrative of a broader point: the US economy continues to struggle with an anemic recovery and long-term structural ills, but the corporate sector has rarely been healthier or more profitable.
U.S. households are still trying to get out from under the prior decade's debt binge, a process complicated by lackluster nominal wage growth. Meanwhile, the public sector is going in the opposite direction: expanding its balance sheet - both from a fiscal and monetary perspective - in an attempt to cushion the deleveraging of the household sector. While this may be necessary in the near term, it is unsustainable over the long term. The fiscal situation is further complicated by the noticeable lack of clarity or consensus on either entitlement or tax reform.
However, despite all of these considerable headwinds, US corporate profits recently eclipsed their 2006 peak (see Figure 1). This resurgence in profits is obviously not purely a function of stellar top-line growth, which would be a difficult trick in a weak recovery. Instead, much of the resurgence in earnings has rested in a rebound in corporate margins, which were decimated during the financial crisis.
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During the last recession, margins troughed in fourth quarter 2008 at around 4.5% of GDP, an all-time low. Since then, profit margins have more than doubled, and at slightly more than 10% are right below their 2006 peak (see Figure 2).
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Given the historical tendency of margins to revert to the mean - the long-term average is roughly 8.20% - and the weak nature of the recovery, many investors are wondering how long this virtuous state of affairs can continue.
The Upside of Lethargy: What's Behind the High Margins
Based on one metric - economic growth - it is surprising that earnings have rebounded as strongly as they have. Corporate profitability is largely driven by growth, as faster economic growth leads to stronger top-line growth. In the past, the level of GDP has driven approximately half of the variation in corporate earnings growth.
The relationship between growth and profitability also extends to profit margins. As top-line growth accelerates, companies - particularly cyclical ones - generate more operating leverage and margins rise. Historically, for every 1% increase in GDP, corporate margins have risen by roughly 0.30% (see Figure 3).According to this simple model, in an environment of 2% growth, investors would normally expect corporate profits of roughly 8.3% of GDP -about 1.7% above current levels.
The tepid nature of the recovery has had another, more benign, effect: it has kept a lid on both interest rates and wages. Since the start of the recovery in third quarter 2009, inflation has, as one would expect, been muted. Headline prices have averaged year-over-year growth of 1.9%, while core inflation - which excludes food and energy prices - has been running at less than 1.4%. Low inflation typically supports margins, as companies pay less for everything from commodities to compensation (see Figure 4).
In particular, the low inflation environment has restrained two key input costs: capital and labor. With inflation below the Federal Reserve's target, the central bank has embarked on numerous rounds of asset purchases, pushing long-term rates down in the process. And in the past, there has been a strong relationship between interest rates and profitability.
Consider a typical investment grade company with a bond rating of Baa (Moody's). You don't need to go back to the 1970s or 1980s to see the impact of today's low rate environment. Back in mid-2006 - a period when spreads between Baa bonds and the 10-year Treasury were close to their long-term average - a company with a Baa rating was paying roughly 6.80% to borrow long. Today, a company with a similar rating is paying less than 5.25%, a significant savings.
While it is true that a slow-growth environment is working against margins, the side effect of slow growth - low rates - is very much flattering margins. Margins may appear high for an environment characterized by 2.0% growth, but they look about right for an economy in which the 10-year Treasury note is yielding 2%.
In addition, labor costs have been restrained. Anemic job growth has hampered consumption and overall growth, but it has also provided companies with enormous bargaining power and employees with very little. As a result, wages are rising at a slow rate, even when compared to the previous two subpar recoveries.
This is particularly true for middle income and lower-middle income workers paid on an hourly basis. As of January, wage growth for hourly workers was rising at a tepid 1.5% year-over-year pace, the slowest since records began back in 1965 (see Figure 5). Part of the explanation lies in the fact that not only is the labor market weak, but inflation is relatively low, providing less of a need for cost-of-living adjustments. However, even after taking into account the low inflation regime, wage growth is historically low. The current gap between wage growth and the Consumer Price Index is -1.50%; effectively, hourly workers have lost more than 1% of purchasing power in the last year. In October, the gap was more than 2%, which represented the largest contraction in real wages since the early 1990s. While a lack of real wage growth is stifling consumer demand, the flip side is lower wage costs and higher margins.
How Margins Could Shrink: The Goldilocks Scenario of Too Hot or Too Cold
While corporations have benefited from the unusual nature of the recovery - as well as very tight management of expenses and capital spending, to their credit - this happy confluence of events will not last forever. Two scenarios could upset this equilibrium: either a sharp deceleration in growth or a meaningful pickup in economic activity, and with it rising wages and interest rates.
In terms of specific factors to watch, we would focus on three quantitative factors and one event: Chicago Fed National Activity Index (CFNAI), yield on the 10-year Treasury note, hourly wages, and finally the extent to which next year's fiscal drag is postponed or avoided.
Starting with the CFNAI, this is our preferred real-time gauge of economic activity. The problem with watching GDP is that it is released with a long lag and is subject to significant revisions. Investors should instead focus on leading indicators of growth. The CFNAI not only does an excellent job of measuring growth in the current quarter, but it also produces a reasonably accurate forecast of GDP over the following quarter. Historically, margins have tracked the CFNAI in a similar fashion to actual GDP. As a rough rule of thumb, margins fall by roughly 0.50% for each one-point drop in the CFNAI, which has an average reading of zero. In the event of another recession, the CFNAI is likely to fall to at least -2, which would suggest at least a 1% drop in profitability. In the event of a more severe recession, such as we had in 2009, the drop is likely to be much more dramatic.
However, if instead of too cold, the economy starts to become too hot, margins are also likely to fall, albeit for different reasons. Under this scenario, investors should watch bond yields. Historically, every 1% increase in the 10-year Treasury note has equated to roughly a 0.40% drop in margins.
Third, investors should focus on wage costs - the largest part of the cost structure for most companies. Wage growth - measured by hourly wages - is now roughly one-third of its long-term average. While real wage growth has been weak since the late 1990s, the situation has become much worse in recent years (as recently as December 2009, hourly wages were growing by 4% year-over-year). When wage growth begins to revert to its longer-term mean, this will start to crimp margins.
Finally, to the extent that growth is probably more of a near-term risk than inflation, in addition to watching quantitative metrics such as the CFNAI, investors will also want to pay close attention to Washington, especially as we near the election. As we've written about in the past, a combination of expected tax hikes and spending cuts will create enormous fiscal drag in 2013. The Congressional Budget Office estimates that unless current policy is changed, next year's fiscal drag will dampen growth from a potential of 2.75% to 1.10%. In the context of a fragile recovery, this will push the United States back toward "stall speed" and raise the risk of another recession. In the current economic context, this is probably one of the biggest risks to not only corporate margins, but to the broader recovery.
Core inflation is creeping higher, but in the near term we would be more worried about slow growth than rising prices, particularly given the risk for fiscal drag in early 2013. As we've discussed in previous pieces, we believe that the fragility of the U.S. consumer is underappreciated. If consumers face the prospect of higher taxes and lower transfer payments next year, there is a serious risk to both growth and margins.
Sector Allocation: Focus on the Why
Sooner or later, margins are likely to revert back toward their historical mean. Investors are therefore reasonably considering how to best position their portfolio for that time when corporate margins start to shrink.
In considering what segments of the market are likely to prove the most resilient, it is critical to have a view on what causes margin compression: slowing growth or rising input costs. To evaluate the impact of economic environments on corporate margins, we quantified the impact of four economic regimes on margins: high growth and high inflation; low growth and high inflation; high growth and low inflation; and low growth and low inflation. Individual quarters were grouped based on whether economic growth and inflation were above/below the historical median (we also tested other breakpoints, and the results are broadly similar). In order to isolate key patterns, we grouped all 10 economic sectors into three broad buckets: cyclical (industrials, consumer discretionary, finance, and technology), defensive (healthcare, consumer staples, utilities, and telecom), and resource (energy and materials).
While this type of exercise can often produce counterintuitive results due to the relatively small number of economic cycles that are measured - for example, energy companies probably don't benefit from low growth, but rather the empirical result simply reflects the impact of the stagflation of the 1970s - the analysis reveals some broad principles.
First, investors worried about an economy that is too hot - defined by rising inflation - should favor energy and materials companies. On average, these two sectors have significantly higher margins during periods of high inflation when prices are rising (see Figure 6). While these sectors can be and are often considered cyclical - in the sense that demand for natural resources increases with overall economic activity - at least historically inflation has been a much more critical determinant of their margins. During high inflation periods, average margins were around 8.5%, regardless of growth. In contrast, when inflation was low, margins averaged less than 7%.
The second broad conclusion, the classic defensive sectors - utilities, healthcare, and consumer staples - have at least historically fulfilled their role, at least as far as corporate profitability is concerned. All three of these sectors have margins that are relatively invariant to both inflation and growth. This is not surprising as companies in these sectors are more likely to maintain pricing power and witness more stable end-user demand than companies in sectors that sell more discretionary products and services.
Third, not surprisingly, growth matters for cyclical sectors. Margins average 11.3% during high growth periods, about 1% higher than during low growth periods. High growth/low inflation environments are best, while low growth/low inflation environments are worst. This latter point is worth considering for those who worry about not just slow growth but deflation as well. Under regimes when both inflation and growth were below the median, margin compression was particularly severe.
Finally, while we've not addressed interest rates directly - the conclusions broadly correlate with the results on inflation - one point is worth highlighting. If you're worried about a long-term backup in rates, avoid financials. Financials get hit on numerous fronts when rates rise. First, their cost of funding rises as short-term rates increase. Second, the value of their fixed-income holdings goes down. As a result, financials have historically been the most sensitive to higher rates, with margins 2.5% lower on average in high rate environments compared to low rates.
Some say the world will end in fire, Some say in ice.
-- Robert Frost
For several years now, investors have had to contend with what seems like an unending series of bad news: a global financial crisis, an anemic and uneven recovery, a feeble labor market, an existential crisis in Europe, and the periodic threat of turbulence in the Middle East and the accompanying oil crisis. What has continued to surprise, and accounts for much of the market's resilience, has been the competitiveness and adaptability of the corporate sector. As a result, profits are at record levels and equities appear cheap by most historical standards, particularly relative to bonds.
Ironically, while the corporate sector deserves kudos for its discipline and adaptability, some of the credit should also go to the same negative factors enumerated above. A weak labor market has translated into little wage growth, while the overall lackluster nature of the recovery has contributed to interest rates remaining near historic lows. Both factors have supported the surge in corporate profitability.
To the extent that the recovery continues to be characterized by slow, but below-trend growth, this state of affairs may continue. However, at some point this fragile equilibrium will give way to either another contraction or a more durable recovery. Under either scenario, margins are likely to compress, unless you believe that central banks can navigate the global economy to a permanent nirvana of strong growth and low inflation.
In timing this shift, investors should pay attention to four factors: leading economic indicators, wage costs, long-term interest rates, and the willingness of Washington to address the pending fiscal drag, which may represent a serious risk to the recovery.
If it starts to appear that fiscal drag is unavoidable next year, then beginning in the fall investors may want to begin repositioning their portfolios toward a more defensive tilt. We're skeptical that we'll see a significantly robust recovery to push inflation or interest rates higher this year, but when signs do start to emerge investors should consider raising their allocation to natural resource companies and lowering - if they have any left - their allocation to financials. In the meantime, we can take some solace in the fact that corporate profitability may continue to provide a floor under the market, even with - and to some extent because of - all the troubles in the world.
Disclosure: I am long IDV.
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