Earnings seasons set to shine light on squeezed margins
The end of an astonishing era of US corporate profitability may be looming as the second-quarter earnings season begins this week, with JPMorgan Chase and Wells Fargo, the giant banks, in the spotlight on Tuesday.
At the same point last year margins were boosted by the effects of the new tax code. Without a similar catalyst this time around, the outlook is murkier.
US corporate profit margins have been climbing for more than a generation, driven by long-term trends such as falling unionisation, automation, industry consolidation, globalisation and the rise of vast, oligopolistic technology companies that throw off cash like confetti.
The financial crisis then spurred many to trim costs and the Federal Reserve floored interest rates. As a result, corporate profits have amounted to more than 12 per cent of US gross domestic product every year since 2009, the longest such stretch since at least the 1960s, according to Schroders.
This has powered a secular increase in valuations. Bridgewater, the hedge fund, estimates that the US stock market would have been 40 per cent lower without the past two decades of margin expansion. But many of the profitability tailwinds are slowly fading.
Softer economic growth, tariffs, rising input prices and wage costs are all likely to eat into profit margins in the coming quarter. Corporate surveys show the highest levels of concern over rising labour costs in at least three decades. This is, of course, welcome news for workers, but ominous for investors.
Analysts expect S&P 500 companies to report a 2.8 per cent contraction in profits in the coming earnings season. Together with the first-quarter dip, that would make it an earnings recession.
The longer-term outlook also looks unfavourable. Forecasting US politics is a mug’s game, but there is chance that a Big Tech backlash could lead to more draconian, profit-sapping regulations. Even setting aside political pressures, rising costs in the developing world make it a less attractive place to offshore jobs.
Investors appear to be subtly girding themselves for a leaner era. Companies that are considered to have stronger pricing power, and therefore more resilient profit margins, have outperformed over the past year.
Corporate America will probably remain very profitable. Labour costs amount to about 13 per cent of revenues for the median S&P 500 company, so even a full percentage-point acceleration in wage growth would reduce earnings per share by less than 1 per cent, according to Goldman Sachs.
Yet investors should keep a keen eye for any hints that margin pressures are intensifying. “There is a decent chance that we are at a major turning point for corporate margins,” noted Bridgewater earlier this year, “and if that is correct, US equities have a major valuation problem.”
And that was even before the S&P 500 hit another record high on Monday.