Equities have staged a useful rally over the past few weeks. The decision by the European Union (EU) to allow the European Stability Mechanism (ESM) to fund banks directly is an important first step in breaking the nexus between sovereigns and banks. The ESM has also been allowed to buy government bonds directly from the open market, as opposed to making loans to governments. Markets have viewed these developments as significantly reducing the chances of a disorderly breakup of the eurozone, at least in the short-run. Fears about a cruel fate for the zone have weighed heavily on risky assets, largely due to its implied negative consequences for corporate profits.
For US equities, currently trading on reasonable valuations, particularly versus bonds, the ability to maintain high profit margins in the wake of a eurozone break-up would seriously test most corporations. While the new expanded role for the ESM will reduce financial tensions in the near-term, real economic activity in Europe will remain soft for the foreseeable future. US corporations with sizeable European exposure are probably still wary of downside economic risks.
US Corporate Profits: Tougher Times Ahead?
The onset of the Q2 earnings season provides a convenient backdrop against which to analyse the corporate sector’s performance. More importantly with mounting evidence of a global economic slowdown, the sustainability of elevated levels of profitability requires critical appraisal. We will look at the forces that have forged elevated levels of US profitability and discuss their durability.
Impressive Secular US Corporate Profitability: 2001 to Present
Corporate profits have historically been a leading indicator of economic activity: profitability tends to trough just before the bottom in real economic activity. The annualised growth rate of post-tax National Income & Product Accounts (NIPA) profits since 1988 has been 7.3% per annum. This compares with annualised nominal GDP growth over the same period of 5%. I have chosen 1988 as the reference starting point, because official estimates for operating earnings per share (EPS) for the S&P500 begin at this point. The annualised growth of S&P500 operating EPS since 1988 has been 6.4% pa.
Without question, there has been an impressive secular improvement in the way US corporations maintain their profitability, particularly during periods of slow or slowing sales growth. Margin expansion is very easy in the early stages of an economic recovery, as fixed costs (labour, interest and depreciation) are spread across rapidly rising output and sales. When times get tougher, however, US corporations have increasingly resorted to aggressive restructuring to prevent margin erosion. The basic aim of restructuring is to reduce the breakeven level of output by cutting fixed costs. This has invariably meant squeezing labour input via permanent headcount reduction or outsourcing. Unit labour costs have accordingly been kept in check for a prolonged period. This is important, given that pricing power for US corporations has been declining since the inception of the World Trade Organisation in 1993.
Specific Factors Behind Impressive US Corporate Profits
Based on NIPA data, post-tax corporate profits as a % of GDP are currently at an all-time high. Profitability was already very high at the onset of the Great Recession. Two factors help to explain the rise in aggregate profitability in the previous economic expansion: 1) the growth of financial sector profits, and 2) growth of foreign-sourced profits. According to NIPA data, between 2001 Q4, the pre-tax profits of the financial sector went from $267bn to peak at $448bn in 2006 Q2. The impressive growth of financial sector profits was partly due to the housing bubble and the use of excessive financial leverage. Meanwhile, profits from the rest of the world rose from $177bn in 2001 Q4 to peak at $619bn in 2008 Q2.
Since the end of the Great Recession, financial sector profits have risen from a low of $195bn in 2009 Q1 to $485bn in 2012 Q1. Pre-tax financial sector profits comprise 24% of total pre-tax corporate profits. The peak in the last economic expansion was 31% in 2005 Q1. Foreign-sourced profits contributed 31% to total pre-tax corporate profits in 2012 Q1.
We are basically attributing over half the level of current pre-tax corporate profits to two sources, namely the financial sector and foreign sourced profits. The high contribution of foreign-sourced and financial sector profits has been in place since 2001. Between 1990 and 2000, these components averaged 40% of total pre-tax profits. Since 2001, this figure has risen to 56%. The near-term risks to the corporate profits outlook would seemingly stem from weak overseas economic activity, along with potential problems in the financial sector.
Risks to the Profits Outlook
The biggest domestic risk to the profits outlook is a policy error. The Fed will not be the guilty party: it could be a dramatic tightening of fiscal policy in 2013. The Congressional Budget Office estimates that fiscal policy could be tightened by 4-5% of GDP if there are no changes to current law. The US private sector cannot fill this vacuum. A recession would be guaranteed under this “fiscal cliff” scenario. Corporate profits would fall. There will also be a secondary impact on the banking system. While private sector credit demand has improved, the reduction in federal government borrowing would adversely impact bank credit and asset growth, thereby undermining profitability.
The other big risk to the corporate profits outlook is significant economic slowdown outside of the US. The eurozone and the UK are both currently in recession. Meanwhile, China’s economy has been clearly slowing during 2012. The endgame for countries with issues about fiscal sustainability within the eurozone has yet to be fully determined, despite the expanded role of the ESM.
Europe Is More Important Than Asia for US Companies
Despite all of the hype about emerging markets, Europe is still the most important area for foreign-sourced sales and profits for S&P500 companies. In 2010 (update for 2011 expected shortly), sales to Europe by S&P500 companies amounted to 7.6% of total S&P500 sales. The sales figure for Europe in 2010 was more than double that for Asia (3.4%).
The world economy in 2012 has been characterised by convergence via slower emerging market growth in response to earlier policy tightening. According to the NIPA measure of corporate profits, foreign-sourced profits declined in 2012 Q1. This component of corporate profits could well come under even further pressure in the coming quarters, as economies outside the US remain weak or slow.
Domestic Non-Financial Profits Faring Okay
While financial and foreign-sourced profits have been important drivers behind recent elevated levels of profitability, the domestic non-financial sector has also impressively grown profits and margins during this expansion. Pre-tax domestic non-financial profit margins are now at their highest levels since the early-1960’s. How sustainable are these margins?
Non-financial domestic corporate profits continued to grow in 2012 Q1. Their continued growth will depend on further US economic expansion. Although the Fed recently downgraded its central tendency forecasts, the baseline scenario is for continued economic growth. Meanwhile, the Fed forecasts that the unemployment rate will remain elevated for the next 2 years, implying that labour input could still continue to be squeezed. This enhances the chances of unit labour costs remaining subdued, helping to at least preserve margins. Rising unit labour costs are normally the main source of margin degradation.
The wildcards to boosting margins are labour productivity and pricing power. If better combinations capital and labour can reduce total unit production costs, then there is potential upside to margins. Meanwhile, future pricing power will partly depend on exchange rate developments: appreciation of the US dollar will import deflation and limit corporate pricing power.
Constructing Realistic Earnings Expectations
Stock prices reflect investors’ perceptions about the future profitability of the corporate sector. Given the slowing world economy and risk of fiscal tightening in the US, earnings expectations are probably in need of recalibration. This should be an interesting process: 2012 Q1 operating S&P500 EPS ($24.24) was the third highest in history, while operating margins were also very high (9.1% versus an historic average of 7.2%). Both the S&P500 operating EPS and operating margins are expected to hit all-time highs in Q2.
During Q2, the “bottom-up” estimates for operating S&P500 EPS for the quarter and the full calendar year have been revised downwards by -2.7% and -0.2% respectively. Given the global macroeconomic backdrop, it seemingly makes sense for 2012 H2 earnings expectations to capture economic deceleration. The S&P500 is currently selling on 13 times calendar 2012 EPS, which is expected to rise 8% for the year. Against a backdrop of EPS deceleration and macroeconomic uncertainty, it is difficult to justify any P/E multiple expansion between now and year-end. More importantly, 2013 EPS is expected to rise +14%. This estimate may come under the microscope for revision later this summer.
Bonds versus Equities: Does Something Need to Give?
Despite the rally in risky assets in June, 10-year US Treasury note yields continue to remain at very low historical levels. The outcome of the recent Greek elections and EU summit, along with the extension to Operation Twist, should reduce the likelihood of an Armageddon-type scenario. US corporate bond spreads for lower-and-speculative grade issues over US Treasuries remain, however, stubbornly high. Either the holders of corporate equities are being too optimistic or bondholders too pessimistic. At some stage, one camp needs to give ground, depending how current macroeconomic uncertainty plays out.
Summary and Conclusions
Elevated US corporate profitability is partly attributable to just two sources: 1) the financial sector, 2) foreign-sourced profits. The domestic non-financial sector has, however, also improved its profitability. Disciplined management of fixed costs, particularly labour, has been a major source behind the improvement.
The biggest risks to US corporate profits stem from the weakness in overseas markets, along with possible trouble in the banking system due to a policy error. Fiscal policy tightening remains the biggest treat to US economic expansion. A continuation of sluggish US growth enhances the chances of elevated domestic non-financial profit margins being preserved.
Earnings expectations for 2012 H2 require downward revision due to a slowing global economic backdrop. Decelerating earnings growth and an uncertain macroeconomic outlook makes P/E expansion difficult, if not impossible, to justify.
