MACRO AND MARKET PERSPECTIVES

Profit margins under pressure

Mar 14, 2019

The deceleration in economic growth – and the entry of the US into the late stage of its expansion – casts a shadow on corporate profit margins. This year we could see a US-led earnings recession – typically defined as two straight quarters of annual declines in earnings. Some of the decline is explained by the unfavourable base effects from last year’s US corporate tax cuts. Yet other macro factors also suggest that US profit margins are likely to contract over the course of 2019.

Contracting margins

We believe global economic activity should slow this year to a level closer to potential growth rates. What does this mean for corporate profits and margins, especially as the U.S. enters the final phase of its expansion?

The deceleration in economic growth casts a shadow on corporate profit margins. Potential margin compression and slower gross domestic product (GDP) growth could compound this year into a full-blown U.S.-led global earnings recession – typically defined as two straight quarters of annual declines in earnings.

Some of the decline is explained by the unfavorable base effects from last year’s U.S. corporate tax cuts. Yet other macro factors also suggest that U.S. profit margins are likely to contract over the course of 2019.

As the fourth quarter 2018 earnings season closes, some top-down earnings forecasts for 2019 have been revised to stall-speed– especially in the US relative to Europe – even as bottom-up estimates and consensus forecasts remain more upbeat. Top-down forecasts look at aggregate macro data related to profits and margins, while bottom-up estimates focus on aggregated data about individual companies and sectors.

The late-cycle compression in margins limits inflationary pressures and allows central banks to be patient in their policy normalization. But falling profitability also reduces incentives to invest and to hire. The two-way feedback loop between the cycle and margins suggests there will be a fall in margins this year and potentially an outright earnings recession, in our view. Current consensus estimates appear too high, potentially leaving both equity valuations and credit markets exposed.

Analyzing the cyclical behavior of U.S. profit margins is complicated by the secular rise in margins since the 1980s. We therefore need to disentangle this trend increase from the cyclical swings. The chart below shows our estimate of U.S. corporate pre-tax profit margins based on national accounts data (NIPA). 

US corporate profit margins

The cyclical pattern is clear – and also applies to earnings. Since the late 1980s, profit margins have contracted sharply in the late-cycle phase highlighted in orange above, snapping the mid-cycle expansions. Margins typically trough in a recession and hover sideways early cycle.

An unusual expansion

But the current extended expansion does not appear to be following the same template. Margins expanded in the early phase, followed by a mid-cycle drop in margins – driven by the China, energy and U.S. dollar shocks of 2015-2016. Margins picked up again at the start of 2018. This underscores how the recovery from the global financial crisis has been unusual in many respects – and there is no reason why it should not be different for margins, too. Profit margins have been boosted over time due to secular trends such as globalization and increased industry concentration.

By adjusting for these long-term shifts we can see more clearly their cyclical swings. The chart above on the right shows the spread of margins in percentage points relative to their long-term trend. Viewed this way, profit margins look soft in this phase of the cycle.

Bottom line: We believe margins have likely peaked and expect a material contraction in 2019 – a typical late-cycle pattern, we find.

U.S. margins lead

Earnings are a key driver of equity returns. That’s why we care about profit margins, which we expect to fall this year.

But not all profit margin data are created equal, we find. We base our analysis on the profit margins in the national accounts data (NIPA) from the U.S. Bureau of Economic Analysis. We prefer to focus on this profit margin data for several reasons.

First, profit margins derived from NIPA data tend to lead the S&P 500-based profit margins. Over the past the 30 years, turning points in NIPA margins have preceded those for the S&P by an average of three quarters. See the chart below. NIPA data feature a larger and more comprehensive sample of companies –including private, unlisted companies that play a greater role in the economy.

NIPA profit margins

Second, NIPA data have a longer history than S&P 500 data. Third, NIPA data separate domestic and repatriated foreign profits, while the S&P 500 data only separate revenues. Given the rising role of China in global growth, S&P 500 companies are increasingly sensitive to foreign earnings. Fourth, NIPA’s accounting methods ensure uniform depreciation schedules are being applied, while excluding one-off debt write-downs and land depreciation. And fifth, NIPA data are based on a broader set of data sources than just regulatory filings. NIPA data can be revised regularly and materially. But we find that unrevised NIPA profit margins still lead S&P 500 margins similar to the chart above, so we don’t view this as a major drawback.

Where are these NIPA profit margins headed as we enter the late phase of the U.S. business cycle? The chart below shows NIPA profit margins “detrended” – stripped from the influence of long-term secular shifts such as globalization and increased industry concentration. We do this so we can see the cyclical swings in profit margins more clearly. Next to this on the chart is a forecast (see the “Expected margin” line) of this detrended margin over time. This forecast is made using a statistical model that includes measures of economic overheating (the output gap), measures of real unit labor cost growth, measures of output price inflation and measures of output growth.

Detrended profit margins

Historically, profit margins have dropped from their peaks in the late phase of the economic cycle. This may sound counterintuitive: textbook economics would suggest that companies have more pricing power when the economy operates at or above full capacity and inflation picks up. But under imperfect competition (the norm in most markets), companies tend to give up pricing power to gain or defend market share. The willingness to give up pricing power will likely reflect adjustment costs in both capital and labor.

Theory shows that the more monopolistic markets become, the more companies tend to eat into margins to defend market share when revenue growth starts to slow. The more margins fall, the lower inflationary pressures are – possibly further extending the economic expansion.

The stage of the cycle also matters: for most of the business cycle, margins move with the output gap. Profit margins expand in the mid-cycle phase as the output gap converges to zero and full capacity is reached. But in the late-cycle stage, margins move in the opposite direction of the output gap. The more the economy overheats, the lower the margins. During the late cycle, costs tend to rise most quickly just as revenue growth heads lower, overwhelming the increased output price inflation.

Our estimates show that margins are likely to decline this year, falling further below their secular uptrend. Much of this is due to rising overall capacity utilization – the stage of the business cycle – which we expect to rise further during 2019. Together with a rise in unit labor costs, this will outweigh the projected increase in the GDP deflator, a measure of price inflation.

Tracking earnings

We have created a new tool for tracking developed market (DM) earnings. Our new earnings tracker leverages our existing suite of macro indicators, including our Growth and Inflation GPS, trade nowcast and additional inputs.

The chart below shows trailing 12-month earnings growth (based on EBITDA – earnings before interest tax depreciation and amortization) for the MSCI World and our new earnings tracker. Our earnings tracker suggests earnings growth should drop to zero year-on-year by the middle of the year – and points to some stagnation in DM earnings this year.

BlackRock Earnings Tracker

Most of the inputs into our tracker are pointing down. Our Growth GPS is ticking lower, while the proxy for unit labor costs has been rising as nominal wage growth has outstripped productivity. Yet the biggest driver of the G3 earnings retrenchment is our global trade tracker – DM earnings are sensitive to the global manufacturing and trade cycle.

What would it take for our earnings tracker to rise? We would need to see a rebound in annualized global trade growth to about 3.5% from current levels near -5%. We believe this is possible. A very real upside risk to our outlook is that stimulus in China and Europe could spark an upturn in the global economy in the second half of the year. Any such rebound in global growth could more than offset the late-cycle drop in margins.

Our view is gloomier than the market’s. Our estimates for US profit margins and nominal growth – implied by our Growth GPS – point to a 1% drop in national accounts data profits in 2019 and just below zero for S&P 500 pre-tax earnings. The calendar effects of 2018’s earnings acceleration mean that earnings growth near zero this year would require a few quarters of quarterly declines.

What earnings growth is priced in? The consensus S&P earnings growth forecast for 2019 is 4.4%: based on current price-to-earnings ratios and our estimate of the equity risk premium, we see the market is pricing in real earnings growth just below 3% (all according to March 2018 Thomson Reuters data).

We focus on the US because it has led the current business cycle. There is evidence that through past cycles, the U.S. data have led DM profits and margin data too. And other countries don’t have the same detailed national accounts data.

Equity markets do not appear to be pricing in an earnings recession, and debt issued by highly leveraged companies could be particularly exposed. At face value, entering the late-cycle phase and an outright earnings recession appears a difficult backdrop for risk assets. Yet late-cycle stages and earnings recessions have historically been bullish for equities – as long as they don’t coincide with a full-blown recession.

What are some of the other implications? US equities seem to have decoupled from global equities thanks to their lower beta (i.e. their sensitivity to short-term cyclical swings in the economy) and higher profit margins. Since the late 1980s, US equities have outperformed global stocks. 

The only prolonged period when U.S. equities underperformed was in the early 2000s when the rise of China and other big emerging markets (EM) caused MSCI ACWI to outperform for about six years. Higher potential growth in the U.S. vs. other DMs and lower risk premia in the U.S. vs. EMs should keep supporting the secular outperformance of the U.S. against the rest of the world.

US vs. World equity performance

Jean Boivin
Global Head of Research, BlackRock Investment Institute
Jean Boivin, PhD, Managing Director, is Global Head of Research for the Blackrock Investment Institute and is a member of the EMEA Executive Committee.   His ...
Elga Bartsch
Head of Economic and Markets Research, BlackRock Investment Institute
Elga, Managing Director, heads up economic and markets research at the Blackrock Investment Institute (BII). BII provides connectivity between BlackRock's ...
Co-Chief Investment Officer of Active Equity and Head of European Active Equity, BlackRock
Kate Moore
Chief Equity Strategist, BlackRock Investment Institute
Kate Moore, Managing Director, is Chief Equity Strategist for BlackRock and a member of the BlackRock Investment Institute (BII). She is responsible for ...