Monday, 24 September 2018

Saft on Wealth: High profits face a test

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With corporate profit margins at record levels, the stock market faces a challenge because the logical next move may well be down.

James Saft, Reuters Columnist

Economy-wide corporate profit margins are over 10 percent, not only the highest on record, but now fully 20 percent higher then they were at the most recent peak, before the onset of the great recession.

How we got here is pretty clear – technological innovation came alongside globalization, allowing for investment in processes and technology in combination with wage-lowering off-shoring of jobs.

Goldman Sachs this week argued that equities were as attractive relative to bonds as they have been in a generation, a bold call, and one based in part on an expectation that equity popularity is now at a low ebb and will rise.

We may now be seeing the first signs that profits are set to flag. With more than half of the S&P 500 companies having reported fourth-quarter earnings, 30 percent have recorded negative earnings surprises, according to Richard Bernstein of Richard Bernstein Advisors.

If that trend continues among the remaining companies, we’ll have experienced the worst reporting period since 2008.

U.S. companies really did remarkably well in the aftermath of the financial crisis. Not only did they grow profit margins, keeping a very sharp eye on the bottom line, they did so while repairing balance sheets. That left them lean and able to invest if demand comes back in earnest.

What can’t be denied, though, is that the corporate sector got a huge helping hand from the government, which picked up in spending where corporations and households left off. The government engaged in large-scale deficit spending which translated, inevitably, into profits for the private sector.

On the face of it, these sets of circumstances really argue for a bout of mean reversion, with profits falling due to a likely mix of falling government spending or higher wages. As always, the alternative to mean reversion is that we are experiencing a structural change in how the economy works.

This time may indeed be different, but this is a dangerous possibility to entertain.

“Not only can the profits equation help us understand the drivers of past performance, but it can also help us frame the likely outlook for margins. Corporate investment may increase slightly from today’s levels, but to really surge would require a strong economic recovery and the return of Keynes’s infamous animal spirits,” James Montier of fund manager GMO wrote in a note to clients. “Leading economic indicators don’t suggest that this is currently on the horizon. Likewise, the housing starts data suggests that housing investment is likely to be essentially flat.”

Montier continued: “The government deficit may stay high this year, due largely to it being an election year. However, it is almost unthinkable that it will remain at current levels over the course of the next few years. As such, unless households start to re-leverage or the current account improves significantly, and assuming that the government moves toward some form of deficit reduction plan, corporate profits are likely to struggle. From this perspective, a structural break in profit margins looks to be difficult.”

Can P/E ratios rise?

This has been the remarkable story the past three or so years. Profits have not been driven, as they usually are, by investment that translates into cash flow for the companies which sell the things other companies are investing in. Instead, profits have been driven by deficit spending by the government.

Once the election cycle is through, expect some form of plan - hopefully a gradual one - to reduce the deficit. And, since every dollar spent by the government is one in the pocket of a consumer or the till of a company, that’s going to be a difficult hurdle for stocks. Households too still have work to do saving for retirement and re-building their own balance sheets, giving them limited ability to drive profits.

There is also the possibility that a stronger job market and rising costs of labor in emerging markets will allow for the first real wage gains in the U.S. in quite some time.

Equity prices could also be supported if, for whatever reason, the market decides that a given dollar of profit is worth more. That would mean a rise in the price/earnings ratio. Current P/E ratios are reasonable historically, so this isn’t out of the question.

That might be driven by a shortage of growth or, conversely, if a bond market sell-off makes equities look more attractive in comparison to fixed income.

Goldman Sachs this week argued that equities were as attractive relative to bonds as they have been in a generation, a bold call, and one based in part on an expectation that equity popularity is now at a low ebb and will rise.

The race between stocks and bonds is a bit of a glue-factory derby, with both runners showing clear vulnerabilities.

For stocks, given the overall economic picture, the strength of earnings recently is clearly one of those weaknesses.  

(At the time of publication James Saft did not own any direct investments in securities mentioned in this article. He may be an owner indirectly as an investor in a fund.)

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