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GLOBAL MACRO RESEARCH CORPORATE PROFITS AND THE GROWTH CYCLE
FEBRUARY 2020
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WHY MARGINS MATTER
• High and expanding margins provide a backdrop where corporates are able to plan investment decisions with a higher level of confidence. Conversely, periods of margin contraction make corporate behavior more defensive which, in aggregate, makes the economy more vulnerable to shocks.
• In all of the post-war recessions experienced by the US, it is a fall in investment spending that has consistently been the largest contributor during contraction phases.
ANALYZING THE CURRENT CYCLE VERSUS HISTORY
• The initial acceleration in margins at the beginning of this cycle was one of the sharpest from our dataset, in part thanks to the severe decline seen in the global financial crisis. Today, margins remain above their cycle low but have showed a declining trend in recent years.
• Cost control, rather than revenue growth, has been a key driver of margins in this cycle. This is part of the reason why the labor share of US growth has declined significantly.
MARGINS ARE LIKELY TO DECLINE, BUT IT SHOULD BE MANAGEABLE
• A fall in margin growth seems likely in coming years, the pace and extent of this decline is unlikely to prompt a sharp change in corporate behavior. Indeed the current strength of US growth and supportive base affects in the cost component means that a corporate led recession seems unlikely before the US election in 2020.
• Insight bottom-up industry analysis shows early signs of margin pressure, however this mostly stems from the cost component rather than the demand component. When viewed through the lens of corporate financing balances, US corporates are in a strong place to absorb modest margin squeeze. THE US ECONOMY HAS ENJOYED ITS LONGEST PERIOD OF ECONOMIC EXPANSION IN 165 YEARS. WE BELIEVE THAT AN END TO THE CURRENT CYCLE DUE TO POLICY ERROR (I.E. CENTRAL BANKS OVERTIGHTENING TO COUNTER RISING INFLATION) SEEMS UNLIKELY. THIS NOTE WILL EXPLORE AN ALTERNATIVE RISK TO THE CURRENT CYCLE – FALLING PROFIT MARGINS.
US CORPORATE MARGINS OVER HISTORICAL BUSINESS CYCLES
WHY MARGINS MATTER
In our recent publication ‘Asset Allocation and Growth Cycles1, There is a large body of investment research highlighting we discussed the reasons for, and the consequences of, the link between profit margins and return on equity. When lengthening business cycles. Our conclusion was that a viewed through a return on equity (RoE) lens (margins x efficiency combination of structural economic change and developments x leverage) the changes in net margin component explains in the policymaking framework has made economies less the vast majority of changes in RoE. It follows that changes in susceptible to recessions. The cause of recessions in more recent margins also have a strong link with stock price performance decades has changed, with financial sector forces more dominant and as a consequence tend to be an important driver of than traditional causes such as monetary mismanagement or corporate management behavior. industrial/oil price shocks. High and expanding margins provide a backdrop where corporates However, all cycles must eventually end, and they don’t are able to plan investment decisions with a higher level of simply die of old age. As the taming of inflation has given confidence. Conversely, periods of margin contraction make the policymakers more flexibility to use the tools at their disposal economy more vulnerable to shocks. This is because low or falling to sustain economic expansion, we believe that an end to margins force companies to be more cautious when making both the current cycle due to policy error (i.e. central banks hiring and investment decisions. A breakdown of the growth overtightening to counter rising inflation) seems unlikely. dynamics within recessionary periods (Chart 1) highlights the key This note will explore an alternative risk to the current cycle – falling role of investment as a driver of down-turns. In all of the post-war profit margins. We view profit margins as an important driver of the recessions experienced by the US, it is a fall in investment spending economic cycle. We can demonstrate that profit margins impact that has consistently been the largest negative contributor during corporate behavior with falling margins leading to a reduction contraction phases. So changes in corporate profitability that affect in investment and hiring which ultimately impacts growth. companies’ investment intentions are a key factor to watch.
Chart 1: Falling investment has been the key driver in every post-war recession2
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1 https://www.insightinvestment.com/globalassets/documents/recent-thinking/global-macro-asset-allocation-and-growth-cycles.pdf 2 Source: BEA, Thomson Reuters. Data as of December 31, 2019. Contribution to US GDP growth during past 11 recessions. 3 4 We can also illustrate how corporate profits lead the labor market. When profits decline, this subsequently leads to a deterioration in employment. A fall in hiring then ultimately leads a decline in GDP growth. Chart 2 shows the leading nature of profits in the past nine economic cycles (i.e. since 1953).
The rest of the note explores the historical relationships between margins and the business cycle and how current margin dynamics may evolve. This is particularly relevant given growing evidence that the current Trump administration’s use of tariffs is already having a detrimental impact on US corporate profit margins. In short, the impacts of tariffs are a cost that needs to be borne somewhere. China may be bearing some of the pain, either directly or via currency depreciation but a substantial part of the burden is falling on US companies absorbing costs that they are unable to pass onto their end consumers.
Chart 2: Profit cycle also leads employment3
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Annual change (% ) 0 -10 -2 -15 Quarters from the peak of the GDP cycle -20 -4 -25 -4 -2 024681012 14 16
GDP: LHS Payrolls: LHS Profits: RHS Lorem ipsum To illustrate the point, Chart 3 shows the percentage of small business in the US making capital expenditures has been drifting down since early 2018, which coincides with the start of trade tensions. This data is provided NAME SURNAME by the National Federation of Independent Business (NFIB) from their monthly small business survey.
Chart 3: US corporate behavior starting to turn down. NFIB survey – % of businesses making capital expenditure during last 6 months4
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3 Source: BEA, Thomson Reuters. Data as of December 31, 2019. US profits, GDP and employment from the peak of the last nine cycles – average annual change, %. 4 Source: NFIB, Bloomberg. Data as of December 31, 2019. 5 MAPPING MARGIN CYCLES
To examine the typical relationship with margins and the business cycle, we begin by splitting our margin series into discrete periods coinciding with each US business cycle (as defined by the NBER). Chart 4 shows that margin growth accelerates in the recovery phase of the cycle, peaks some time during mid-cycle and that falling margins tend to be a precursor for recession. Another observation is that margins also appear to have a ‘mean reverting’ quality. An intuitive fundamental explanation for this is that higher margins will be eroded either through competition or increased labor costs (as employees demand a greater share of profits).
Chart 4: US corporate margins generally peak before recessions5
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We can then illustrate the typical pattern for US profit margins along the business cycle by taking a simple average of margins for each cycle above and normalizing cycle length (i.e. each cycle normalized over time period 0-100%). The result is a ‘stylized’ path for margins which shows that margins typically peak before the end of the business cycle and fall during recessions.
Chart 5: A stylised view of the US corporate margin cycle6
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Clearly this stylized margin cycle ignores cycle length (i.e. time), which is an important consideration, particularly given the longevity of the current cycle. This is the issue to which we turn next.
5 Source: BEA, Bloomberg, NBER. Data as of December 31, 2019. Annual US profit margins mapped to last 10 business cycles. 6 Source: BEA, Bloomberg, NBER. Data as of December 31, 2019. 6 HOW DOES THE CURRENT MARGIN CYCLE COMPARE?
In Chart 6, we compare the path of the current expansion phase with other historical margin cycles. This includes some recessions caused by shocks stemming from oil spikes or financial crises, as there are very few recent recessions where such events weren’t a contributing factor.
Chart 6: Sharp post global financial crisis bounce led to a strong, and now long, margin cycle7
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Each line above represents the ‘cumulative change’ in margins over each cycle and this is plotted against cycle length in months. There are a few conclusions we can draw from this: • The current cycle has now been the longest on record • The initial rebound from the crisis was one of the sharpest from our dataset • Margins remain above their cycle lows but have showed declining trend in recent years
There are notable differences in this cycle when we look into the drivers of profit growth. In simple terms, profit margins represent the difference between revenue and cost. Whilst the longevity of this economic cycle is without precedent, its strength has been sub-par compared to those of recent decades. In that regard, cost control, rather than revenue growth, has been a key driver of margins in this cycle (see Chart 7). This is part of the reason why the labor share of US growth has declined significantly since the GFC (see Chart 8).
Chart 7: Drivers of profit growth this cycle8 Chart 8: Labour share of real GDP – percent8
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40 (%) 55 56% 20 54 27% 53 0 Previous cycles Current cycle 52 (1949 - 2009) (Sep 2009 - present) 51 Margin Revenue 1950 1960 1970 1980 1990 2000 2010 2020
WHERE DO MARGINS GO FROM HERE?
What is clear from Chart 6 is that margins have now been declining for multiple years. The key concern is at which point this decline could start to signal a significant deterioration in fundamentals. Therefore forward expectations for margins and how we can monitor these for signs of deterioration become the key concern. The next sections explore this in more detail from both a top-down and bottom-up perspective.
7 Source: BEA, Bloomberg, NBER. Data as of December 31, 2019. US profit margins rebased to the low point of the economic cycle. 8 Source: Bloomberg. Data as of December 31, 2019. 7 AN INTRODUCTION TO US PROFITS
US MARGIN DATA SERIES: NIPA profits versus S&P GAAP
In order to properly analyze the Coverage Accounting principles relationship between profits and the NIPA data is produced by the US Bureau As the primary source for NIPA data is business cycle, we need a dataset that of Economic Analysis (BEA) using tax returns, the series is produced using is both consistent over time and has a corporate income tax returns. This means tax accounting principles, whereas GAAP history spanning multiple cycles. The two that the data covers all companies in the profits use financial accounting principles. most frequently used sources for US profit US, both publicly traded and private. The The differences between these two data are the national income and product S&P 500 data set covers the largest9 500 practices is more nuanced than merits accounts (NIPA) and reported profits publically traded firms at any given time the scope of this note, but can be on the S&P 500, which follow generally and so the composition shifts frequently. summarized as follows: firstly, there accepted accounting principles (GAAP). Thus the NIPA series has a much more are differences in the timing of when These two series tend to exhibit similar comprehensive coverage of firms and certain revenue and expense items are trends over multi-year time periods the sector composition more accurately recognized (e.g. depreciation treatment) but on shorter time horizons they can reflects that of the US economy. and secondly, there are some accounting diverge significantly. There are a myriad items that are included in one set The difference in sector makeup of reasons for why the two time series of standards and not the other is particularly interesting given can diverge but it can broadly be (e.g. employee stock options). the increasing dominance of the broken down into two factors; technology sector on S&P profits. We use NIPA data for our analysis due coverage and accounting principles. to the fact it has a longer history, much broader coverage and consistency in Chart 9: NIPA versus GAAP profit margins10 methodology. To generate a margin time series we use NIPA reported profits 14 as a percentage of nominal GDP and we have found this provides a reasonable 12 proxy when compared to S&P 500 10 reported net margins (which are only available from 1990). We do acknowledge 8 that one limitation for using NIPA is that (%) 6 it is subject to large revisions (caused by newly available tax information). 4
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9 Source: Subject to a number of requirements including profitability and public float.10 Source: BEA, Bloomberg. Data as of December 31, 2019. 8 RECENT DIVERGENCE: NIPA margin versus S&P GAAP
If we zoom into Chart 10, it is notable there Coverage and company size Tax policy has been recent divergence between the As explained above, the sector In 2018, the Trump administration reduced NIPA series versus S&P. NIPA profits have composition of the two data corporate tax from 35% to 21%. This has been been trending down since 2014 while S&P series is different. Recently we reflected in higher after-tax profits for S&P reported margins increased from early have observed profit margins firms, where firms report quarterly. However, 2016 through 2018. This divergence have been falling for smaller the impact has been less noticeable in became a particularly pronounced companies faster than large firms. NIPA profits which use annual tax return in July 2019, when the BEA revised This is shown in chart 11 below data. There is potential for NIPA profit down NIPA profits $93 billion (4%) for comparing S&P 500 profit margins margins to be revised as more tax return 2017 and $188 billion (8%) for 2018. versus the Russell 2000 Index. information becomes available to the BEA.
Chart 10: The two series show a clear divergence in trend11
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Chart 11: Margins have fallen faster for smaller companies11 Chart 12: Tax reductions have boosted margins11
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- (8) 0 Jan 07 Jan 09 Jan 11 Jan 13 Jan 15 Jan 17 Jan 19 Jan 11 Jan 13 Jan 15 Jan 17 Jan 19 S&P 500 Profit margin Russell 2000 Profit margin (RHS) S&P profit growth (after tax) S&P profit growth (before tax)
THE IMPACT OF BUYBACKS: It is also worth noting that the majority of market commentary on S&P profit growth will refer to EPS growth. While EPS growth is a fair measure of earnings available to shareholders, the growth rate is often much larger than actual profits growth. This is due to the denominator impact of buybacks reducing the float of available shares. In fact, over the past five years, corporate share repurchases have boosted EPS growth in the US by 1.7% per annum13.
12 Source: BEA, Bloomberg. Data as of December 31, 2019. 13 Source: Credit Suisse, 2015 to 2019. 9 THE FUTURE PATH OF US CORPORATE PROFIT MARGINS
TOP-DOWN: THE INSIGHT MARGIN INDICATOR
We use a simple margin indicator which uses a top-down 1 Central view: Moderate growth slowdown with a modest approach to model the near-term path for corporate margins pickup in wages. This scenario modelled the central view of across scenarios for cost and demand. our bottom-up analysis discussed later in this section and fits The margin indicator has the following inputs: with our broader economic view. MARGIN INDICATOR = PRICES – UNIT LABOR COSTS 2 Slow growth and high wage inflation: Here we modelled a more severe slowdown in growth combined with a pickup Where: in wage growth. • Prices = Implicit Price Deflator (Non-Farm Business) 3 Trade war induced stagflation: Here we modelled the only • Unit Labour Costs = Compensation per hour / Implied scenario where margin pressures really start to bite in the productivity per hour near term. This requires both a significant decrease in business • Implied Productivity = Business output / hours worked output and prices and a large increase in unit labor costs. It’s not intended to be an accurate forecast – more a stylistic Our conclusion from a top-down perspective, is that while a fall illustration of what could happen. We deem this useful in light of in margin growth seems likely in coming years, the pace and the conclusions of section one, not least that changes in margins might warn of a change in the underlying economy. extent of this decline in our first two scenarios would be unlikely to prompt a sharp change in corporate behavior. Indeed the Although simple, the margin numbers produced in this way current strength of US growth and supportive base affects in correlate well with actual margin growth numbers. Chart 13 the cost component means that a corporate-led recession shows this relationship using the same NIPA data in section one, seems unlikely before the US election in 2020. here shown in year-on-year terms. By contrast, the margin decline in scenario three caused by In order to construct our top-down view we have looked at three further escalation in trade tensions would lead to significant potential scenarios and analyzed the margin implications for each. reduction in investment and hiring. In this scenario a self-inflicted This included building forecasts for both output and hours worked recession within the next 18 months seems more probable for each scenario, enabling us to develop productivity projections than not. that ultimately feed into our unit wage cost numbers.
Chart 13: Insight margin indicator maps closely with realized Chart 14: Insight margin indicator shows margin decline only margin growth14 a near-term worry in most extreme scenario15
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14 BEA, Thomson Reuters. Data as of December 31, 2019. Insight margin indicator year-on-year versus actual NIPA profit margins growth. of the economic cycle. 15 Source: BEA, Datastream, Insight Investment. Data as of December 31, 2019. 10 BOTTOM-UP: THE INSIGHT ANALYST PERSPECTIVE
To obtain a bottom-up perspective we asked members of the Insight investment analyst team to examine three factors within their sector: revenue, costs and future margin growth.
In aggregate, the analyst view is that slower global growth in 2018/2019 has increased margin pressure for US corporates. However, this was viewed as manageable given the expectation of slower, but still positive, top-line growth and healthy free cash flow generation.
A positive corporate financing gap (operating cashflow less dividends and cap-ex, but not share repurchases), means that the corporate sector is retaining a healthy proportion of the cash that it is generating. Prior to previous recessions, the corporate financing gap has generally become negative, meaning that the corporate sector was reliant on borrowing to fund capital expenditure. With corporates funding capital expenditure with cash from operations rather than debt, this should provide some insulation from small shifts in corporate margins.
The risk to this view would be that the corporate sector has increased financial leverage, not due to business investment, but due to share repurchases. So while retained cashflow is quite strong, debt levels are elevated. It is also unclear if businesses under margin pressure would choose to cut buybacks or capital expenditure first.
11 ANALYST KEY THOUGHTS
REVENUE COSTS CASHFLOW
Slower global trade and manufacturing Increases to input costs appear After tax cashflow has been robust in activity have increased top-line risks for manageable, leaving us comfortable that a recent years built on a strong economy, the transportation sector. meaningful erosion of margins over the and further buoyed by lower corporate near term is not expected. taxes and changes to repatriation rules. Slower growth in Asia and the deferral of business investment due to trade Ultimately, the analyst team sees more Many companies have invested this uncertainty has increased the risk in pressure on costs than revenues. cashflow back into their existing business the technology sector. for expansion and productivity gains, In order for there to be a severe acquisitions, and to increase shareholder Sluggish auto sales with US sales likely to contraction in margins, we would likely returns. decline somewhat next year and China sales need to see pressure on revenues in continuing to contract pose a risk to the addition to rising costs. auto sector. The weaker auto market has already weighed on the chemical sector.
12 FINAL THOUGHTS
The current environment is one in which the likelihood of a traditional policy mistake (i.e. that of central banks overtightening) is unlikely to bring an end to this record expansion, and thus margin trends are high on our watch list of risk factors which could tip the economy into recession. Margins remain above the lows seen at the beginning of this cycle, and this partly reflects the sheer scale of the rebound following the deep pain felt by corporates during the global financial crisis.
Our analysis on the future outlook for margins shows that while a decline in margins seems likely in coming years, the pace and extent of this decline is unlikely to prompt a sharp change in corporate behavior. Indeed the current strength of US growth and supportive base affects in the cost component means that a corporate-led recession seems unlikely before the US election in 2020. That being said, a renewed escalation in trade tensions could lead to a significant reduction in investment and hiring. In this scenario a self-inflicted recession within the next 18 months seems more probable than not.
While margin levels remain relatively healthy in the near term, we continue to remain vigilant for any signs that increased cost pressures are leading to a change in corporate behavior. One such watch factor is the reported cash use for S&P listed companies, which is revealed in quarterly earnings reports. Chart 15 looks at the growth rate in three categories of cash use: capex, dividends and buybacks. The impact of the 2018 tax cut is particularly striking, with a lot of the excess cash provided by this boost used for share repurchases. More important for us will be to monitor the more stable dividend and capex lines, which for now remain in positive growth territory, however the rate of growth has started to decline.
Chart 15: Growth rate of cash use for S&P companies. S&P firms boosted share repurchases with excess cash provided by 2018 tax cut16
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16 Source: Bloomberg. Data as of December 31, 2019. 13 CONTRIBUTORS
Matthew Merritt, David Hillier, Head of Multi-Asset Strategy Group, Portfolio Manager, Multi-Asset Group, Insight Investment Insight Investment
Jonathan Crone, Scott Ruesterholz, Portfolio Manager, Multi-Asset Group, Portfolio Manager, Fixed Income Group, Insight Investment Insight Investment
Michael Ford, Steve Waddington, Portfolio Manager, Multi-Asset Group, Portfolio Manager, Multi-Asset Group, Insight Investment Insight Investment
Lloyd Thomas, Colin Bennett, Portfolio Manager, Multi-Asset Group, Portfolio Manager, Multi-Asset Group, Insight Investment Insight Investment
Gauthier Mavinga, Shantanu Tandon Portfolio Manager, Multi-Asset Group, Portfolio Manager, Multi-Asset Group, Insight Investment Insight Investment
Marcus Williamson, Abhijit Korde, Analyst, Multi-Asset Group, Portfolio Manager, Multi-Asset Group, Insight Investment Insight Investment
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Insight Investment Client Relationship Management @InsightInvestUS 200 Park Avenue, 7th Floor [email protected] New York, NY 10166 Consultant Relationship Management company/insight-investment-north-america 212-527-1800 [email protected] www.insightinvestment.com
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