“Every time we deal with an enemy, we create two more” – Tyrion Lannister
Investors (and human beings) have not had to search hard for things to worry about in recent weeks. From a posturing peacock with nuclear feathers on the Korean peninsula to the unhealthy game of chicken developing in US Congress, we don’t need to look far to explain the recent resurgence of safe-haven assets. As if we needed any further excuses, others are now pointing to apparently ominous patterns in US corporate profitability as a further reason to batten down the hatches and stock up on tinned food and shotgun cartridges…again.
Profits as a lead indicator
There is admittedly some evidence to suggest that profits turn before business cycles. Plotting post-war US economic cycles against NIPA (National Income and Product Accounts) corporate profits data, you find that profit margins do seem to peak ahead of the business cycle more often than not. There is also some intuition here: as production increases as a proportion of available capacity, then there will be a decrease in per-unit fixed costs, and net profit margins – arithmetically the dominant contributor to corporate profitability – should rise. On the flip side, when spare capacity runs out, operating diseconomies and wage demands become harder to manage as the labour market warms up, which in theory leads to margin erosion and cuts to investment spending – historically the main contributor to downturns. Another plausible path could be that firms are forced to raise prices in response to higher wage demands, leading eventually to wider inflationary pressure. An overreaction from the central bank then in time sends the economy into recession.
However, theory is one thing, reality another. For one, measuring an economy’s capacity accurately is a muddy business; meanwhile quoted sector accounts do not easily allow us to distinguish between fixed and variable costs. All this makes it hard to judge with any confidence how much operational gearing (and extra profitability) companies have yet to enjoy. US labour markets certainly continue to tighten beyond most estimates of the natural rate of unemployment, for which we have more evidence this week. However, wage pressures remain muted, consistent with the existence of at least some further unused capacity.
For now, we remain content to argue that with the US and global economy showing sufficient signs of vigour, the US corporate top line is likely to grow by mid single digits in percentage terms, roughly in keeping with the pace of global nominal GDP growth. This, in combination with still subdued but growing wage demands, should be sufficient to deliver some further operational gearing, resulting in earnings growth that easily justifies our continuing overweight to the region, even in the absence of the promised corporate tax cuts, for the next 12 months and beyond.
Of course, none of this is to say that corporate profit margins can rise indefinitely. The dynamic of capitalism is that if companies generate outlandish profits, fresh competition and capital seek to emulate these returns, which tends to drive them lower. Admittedly, this is never quite as easy it sounds in the text books, as those of us who’ve tried to replicate Pfizer or Microsoft in our garden sheds/man caves have found to our cost, but still.
Profits and recessions
Anyway, the observation that profit peaks have often occurred before business cycle peaks may be less useful than advertised. Looking at the post-war recessions, it is hard to find any that were directly caused by a decline in corporate profitability – more often than not exogenous factors seem to beat them to it. For sure, the last two recessions (and burst bubbles) have been accompanied by massive corporate balance sheet write-downs, which, as they were expensed through the corporate sector’s profit and loss statement, led to similarly impressive declines in corporate profitability. However, in neither case was the decline in corporate profits the trigger for the recession, even if it surely played a role in the rapid retreat in corporate investment, so magnifying the recession. As an aside, we also need to be wary of looking at profits data that has benefited from many rounds of tweaks and revisions over the intervening years. In many cases, this is not a view of profitability that was available at the time.
All of this is moot, as right now profitability seems to be increasing, not decreasing, consistent with a world economy in which revenue opportunities are becoming more, not less, abundant. This will not be the case indefinitely of course, but the trend in US corporate profits is not one that we would add to our doomsday scrapbook just yet. Our preferred developed world equity regions remain the US and Continental Europe. The latter no doubt enjoys greater earnings upside, which it is finally starting to deliver on amidst that increasingly vibrant European economic recovery. However, a dominant share of the justifiably surging technology sector as well as a domestic economy that is furthest along the recovery path are just some of the reasons that we still see attractive profits growth and therefore returns potential from US stocks.