Corporate profit margins are two thirds above historic norms. Is this a new normal, or should investors be expecting those margins to fall sharply as they mean revert?
The boom in corporate profitability since the financial crisis, particularly in the U.S., has been astonishing. There, profit margins are now above 10% against a more usual post-war rate of 6% or so.
Historically, profitability has tended to move back to that trend line when it’s shifted far enough away in either direction. Excessively high profit margins have triggered competition, while too low ones have resulted in bankruptcies and the closure of businesses. This tendency to come back to a normal range is at the heart of the case that equities, particularly in the U.S., are overvalued even though current price-to-earnings ratios aren’t that far from average.
For one thing, once earnings are cyclically adjusted–which is to say, once the profits margin is smoothed out–those P/E ratios suddenly look very richly priced indeed.
Why have profits surged? U.S. corporates cut costs dramatically during the bust, slicing employment to the bone in some cases. As sales rebounded, lifted by massive government spending, much of that revenue growth flowed straight into the bottom line.
James Montier of GMO estimated that the government deficit accounted for about three quarters of corporate profitability.
There have also been some special cases lifting the market overall. A recent Barclays note showed that S&P 500 earnings were expected to grow about 1.4% year-on-year during the first quarter of 2012, but all of that improvement was down to Apple.
Could these margins persist? Certainly there seems to have been a rising secular trend in corporate profitability. In the 1970s and 1980s, margins averaged closer to 5%. Since 1990, they’ve been closer to 7%. This might be down to globalization. If it is, and economies remain as open as they have been, despite some of the dramatic strains they’ve been through, corporate margins may well settle at a higher level.
But that’s a big if. What’s more, that level is unlikely to be anywhere near the current 10%-plus.
There are good reasons for expecting margins to fall, not least because government deficits can’t go on forever. As the U.S. recovery seems to be increasingly established, the government will start to withdraw support, through spending cuts and tax rises.
Austerity is unlikely to be good for corporate margins, even if the economy manages to maintain trend growth. What’s more, U.S. companies seem to have started to reverse some of their big job cuts from the recession. That is probably why U.S. unemployment has dropped sharply recently despite relatively muted GDP growth, argued Federal Reserve Chairman Ben Bernanke.
Higher labor costs, an inability to pass inflationary pressures to consumers and less government money all point to declining margins over the coming years if not quarters. And thus to falling equity valuations.