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What Happens When Record US Profit Margins Reverse?

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Global equity markets have been on one of the longest bull runs in the history of financial markets for several years now. March marked the 9th birthday of the current run, with major global equities indices on an upward trajectory since the end of the 08/09 international crisis. Analyst Leuthold Group say the Dow Jones Industrial Average’s bull run is now its longest since post-WWII. In the case of the S&P 500, only the tech-led run of the 1990s was longer and bigger than the current post-financial crisis rally.

Since last summer, respected stock market analysts have been calling the final throes of the present cycle. In August 2017, Russel Napier, founder of the Electronic Research Interchange and author of Anatomy of the Bear, one of the most widely read books on market downturns was quoted in the Financial Times as saying:

“Only twice since 1881 have equities been this expensive”.

His definition of ‘expensive’ was based on the worth of the stock market as a ratio to the average size of corporate profits over the past ten years. On this definition, almost a year ago, the S&P 500 was deep into bubble territory. Over the nine months since last August, the S&P 500 has gained around another 11%. That’s despite a 4.3% drop on the high of late January. Corrections in early February and late March have done little more than take some of the heat out of markets which have this month again been marching strongly up in valuation.

That’s been fuelled by an earnings season that has aggregate S&P 500 net profit margins hit a new record high of 11.1%. That was of course helped by Trump’s slashing of corporate tax. Profit growth, up 25%, has outstripped value growth this year, with the S&P 500 up less than 2% so far this year. That improves the ratio Russel Napier was worried about last year. However, there is again fierce debate around whether the bull cycle is coming to an end.

Some analysts, such as those at Sanford C. Bernstein, believe factors such as low leverage indicate developed equities markets are nearing the end of their bull cycle. Bank of America Merrill Lynch analysts disagree. They believe the fact that macro-economic indicators are “generally above average and improving” indicates we’re still in mid-cycle and there is plenty of fuel left in the tank for further growth.

However, despite global growth forecasts remaining positive, there are several factors that could hit corporate profit levels in the months ahead. Oil has this week hit $80 a barrel, a 75% increase since last June. This will increase logistics costs and commodity prices are also generally higher, increasing manufacturing costs. Interest rates are rising, which will lead to higher costs for debt refinancing and corporations have borrowed heavily, taking advantage of record low borrowing costs in recent years. Wages are also rising.

Companies have been running tighter ships since the financial crisis hit but there are still concerns that profit margins may well peak this year. If that comes to pass what happens next for equities valuations? Those investing online, particularly in US equities but across developed markets including the London Stock Exchange, have been making hay while the sun has been shining. But if profit margins begin to dwindle, how serious is that likely to be for valuations?

A lot will depend on how much of those increased costs can be passed on to the end customer. Inflation rates are rising and that can help companies increase prices. Andrew Boord of Fenimore Asset Management believes the result will be more divergence between the performance of companies. He’s quoted by the Financial Times as saying:

“Companies are starting to see more wage and commodity inflation, and some will struggle to pass that on to customers. It has been a while since we have seen any pressures on profit margins. I suspect we’ll see the market bifurcate between companies that can and cannot pass on rising prices.”

Unless there is any significant and sudden drop in profit margins across the board, and a positive macro-economic should prevent that, a slight average regression in profit margins shouldn’t be overly concerning for those investing online in equities. A wider global trade slowdown, however, could change that. Saxo Bank believes that is the case.

Risk Warning:

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There is no obligation to purchase anything but, if you decide to do so, you are strongly advised to consult a professional adviser before making any investment decisions.

Paul

The author Paul