Pressures on U.S. Corporate Profit Margins
Corporate profits have been flat over the past few years, at the same time that liquidity generation and money moving out on the risk curve has pushed prices up by roughly 40%, pushing up P/Es and compressing longer-term expected returns. Profits have been flat as profit margins have started to decline from record levels, and looking ahead, downward pressure on corporate profit margins is likely to be sustained as the US economy continues to normalize. It is somewhat counter-intuitive that profit growth should slow as the economy improves, but this dynamic is a natural outgrowth of how business interacts with the rest of the economic system. It happens because earnings are much more driven by profit margins than by top-line revenue growth, and profit margins are heavily impacted by a) the pricing power of labor, b) savings rates of other sectors including the government, c) investment activity of business and d) exchange rates. As US economic conditions improve, these forces are working against corporate profit margins after they had previously been highly supportive. The labor market is gradually tightening, the government is increasingly pulling back its stimulation, businesses don’t have a need to catch up on investments, and the dollar is weighing on competitiveness. As a result, pressures on margins are likely to be sustained and the expected real returns of US stocks look increasingly unattractive, especially relative to those in other countries.
P/E ratios expand and contract throughout the economic cycle. Currently they are expanding, sending the US stock market to new record highs with benchmark index returns of 26% to 30% over the past year, even as corporate profits grow at 4% to 6%. When the P/E ratios contract, the market will too.