Profit margins in the US have hit modern-day record levels, and this has been used to help justify high equity valuations. Consensus estimates are for profit margins to remain steady, or even increase from current levels. We disagree for ironclad economic and accounting realities, and think margins will fall, taking equities down too.
Profit margins have, at least until now, exhibited mean-reversion like behaviour. There has been a contention that we have reached a structural break, and profit margins will stay well above their long-term average. We disagree.
Profit margins are high compared to their long-term average, and this is still true (but less so) if you just consider domestic profits, and non-financial profits.
The Kalecki Equation attempts to explain the drivers of profits. It is derived from the flow of funds concept and accounting identities. We’ll just state the equation here – it’s fairly intuitive – but we encourage readers to look up the derivation and the background. The equation is:
Profits = Investment – Household Savings – Government Savings – Savings from Abroad + Dividends
So profits are driven by different sectors of the economy. The following chart, from James Montier at GMO, shows the decomposition of profits over the last 60 years (click on image to enlarge).
The blue part of the diagram – investment spending – has been the largest contributor to profit margins for most of the last six decades. But most lately, government spending has been the main driver of US profits.
However, the US government has been reining in its spending (ie its dissaving), so it is unlikely this will continue to be a major source of company profits in the coming years. The budget deficit has come in from 10% of GDP to less than 3%, and in cash terms has made back half the slump it saw during the financial crisis.
Investment spending has been declining in a world on the hunt for income while rates remain at historic lows. It is unlikely this source of profits bounces back soon. Similarly, we don’t expect to see the household sector ramp up its spending when the household balance sheet remains impaired. Dividends have increased, but are unlikely to increase more, by enough to take the up slack from the fall in the government deficit. Finally, we are not expecting the US to start running a current account surplus any time soon.
So, what are the implications for long-term equity returns if profit margins fall? John Hussman of Hussman funds notes that profit margins on their own are a poor predictor of long-term US equity returns. So are price/earnings multiples. But the two together have a 90% correlation with the subsequent 10 year total return of the S&P, with equal importance.
So then the question remains, are we likely to see more multiple expansion driving long-term equity returns? Given the bulk of the last two years’ equity returns came from multiple expansion, we think it will be difficult for this to help push equities much higher before they return to fair value.
From where we are in the cycle, it is difficult to see what will keep profit margins at current levels that are above long-term averages. If this is the case, then it is difficult to see what will drive equities much higher. The prognosis over the longer term for US equities is thus poor.