Stand or Fall – How Much Longer?

By Russ Koesterich, CFA | 

In an economy with few bright spots, the corporate sector has remained remarkably resilient and unusually profitable. US corporations are generally flush with cash and have managed to maintain historically high margins despite anemic growth and a lack of consumer confidence.

The Upside of Lethargy: What’s Behind the High MarginsBased 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.

How Margins Could Shrink: The Goldilocks Scenario of Too Hot or Too ColdWhile 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.

Conclusion 
Some say the world will end in fire, Some say in ice.

 

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 

The 13^th annual Global Automotive Executive Survey, conducted by KPMG and released on January 5, indicated that US 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.

US 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.

Source Bloomberg 12/31/2011

However, despite all of these considerable headwinds, US corporate profits recently eclipsed their 2006 peak (see Chart 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.

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 Chart 2).

Source Bloomberg 12/31/2011

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.