Peak Profit Margins? a US Perspective

Peak Profit Margins? A US Perspective

FEBRUARY 7, 2019

GREG JENSEN ATUL NARAYAN OLIVER SIMON LAUREN FORMAN

© 2019 Bridgewater Associates, LP ver the last two decades, US corporate profit margins have surged and have contributed more than half of the excess return of equities Orelative to cash. Without that consistent expansion of margins, US equities would be 40% lower than they are today. Margins have been rising for 25 years, and when we look at market pricing, it appears to us that the market is extrapolating further margin gains.

The long-term valuation of equities hinges heavily on power fell, corporate taxes fell, tariffs fell, globalization what happens to margins going forward: if margin gains increased, technology allowed for greater scale and can be extrapolated, then valuations look reasonable; if lower marginal costs, anti-trust enforcement fell, and margins stagnate, then valuations are a bit expensive but interest rates fell. These factors have produced the most not terrible; if margins revert toward historical averages, pro-corporate environment in history. Many of these then equities are highly overvalued. drivers of high profit margins are now under threat. Before we get to analyzing each, the following panel Over the last few decades, almost every major driver shows how everything moved in the same direction, in of profit margins has improved. Labor’s bargaining favor of corporates.

Labor Share of Output Union Members (% Labor Force) 70% 30%

68% 25% 66%

64% 20% 62%

60% 15%

58% 10% 56%

54% 5% 60 70 80 90 00 10 20 60 70 80 90 00 10 20

# of Annual DoJ Investigations by Type World Cross-Border Capital Stock (%GDP) Competition Monopoly Mergers 140% 600

120% 500

100% 400

80% 300 60% 200 40% 100 20%

0% 0 60 70 80 90 00 10 20 70 80 90 00 10 20

50% 16% 14% 45% 12% 40% 10% 35% 8% 30% 6% 25% 4%

20% 2%

15% 0% 60 70 80 90 00 10 20 60 70 80 90 00 10 20

These phenomena compounded on each other as globalization weakened labor’s position, corporates gained political power, and policies reinforced the shift. Many of these pressures that allowed for so much improvement in profit margins are unlikely to continue being supports, and some are likely reverting. We think there is a decent chance that we are at a major turning point for corporate margins, and if that is correct, US equities have a major valuation problem.

US Non-Fin Net Proﬁt Margin (Post-Tax) US Equities 9% Price Index Assuming Flat Secular Margins 8% 3000 US equity prices would be about 40% lower if not for 7% 2500 secular margin expansion 6% 2000 5%

4% 1500

3% 1000 2% 500 1%

0% 0 70 80 90 00 10 20 90 95 00 05 10 15 20

6.5% Margin expansion drove a substantial portion of returns. 5.5%

Globalization, shifts in labor policy, rising concentration in a winner-takes-all environment, 4.5% etc. have led to lower labor share of revenue.

3.5%

2.5%

1.5%

0.5% Falling Labor Costs Margin Expansion EPS Growth Total Return

Below, we walk through the evolution of major forces behind the secular increase in US profit margins.

Decline in Organized Labor Has Reduced the Bargaining Power of Labor

As we show above, the biggest force behind the US profit margin expansion has been the decline in the labor share of output. One factor that has contributed to the reduction in labor’s bargaining power versus capital is the decline of organized labor and unions. This phenomenon has occurred over decades for an array of reasons intertwined with the other forces on margins—like access to pools of cheaper foreign labor and advancing automation technology. In the chart below on the left, we also show what the impact would be if a $15 minimum wage were adopted.

Labor Share of Output Union Members (% Labor Force) Est with $15 Minimum Wage 30% Nixon institutes 70% Ford deregulates trucking price controls 68% Carter deregulates airlines 25%

66%

64% 20% China joins WTO 62% 15% 60% Foreign automakers open plants in non-unionized South 58% NAFTA 10% 56%

54% 5% 60 70 80 90 00 10 20 60 70 80 90 00 10 20

© 2019 Bridgewater Associates, LP 3 As union membership has fallen, the share of employees involved in labor strikes has collapsed, reflecting both the shrinking size of unions and less frequent strike activity among the remaining unions. This again reflects the dwindling power that organized labor can exert over employers.

% Employees Involved in Work Stoppages Productivity-Adj Real Minimum Wage (Indexed to 1995) 4.0% 2.75 2.50 3.5% 2.25 3.0% 2.00 2.5% 1.75 2.0% 1.50

1.5% 1.25 1.00 1.0% 0.75 0.5% 0.50 0.0% 0.25 60 70 80 90 00 10 20 60 70 80 90 00 10 20

While changes in union activity have been smaller in recent years, even small moves toward or away from unionization can be linked to changes in how much firms pay their employees. Over the last 20 years, sectors that de-unionized more saw their wages fall relative to those where union membership remained more constant.

Union Membership by Sector vs. Change in Wages 3.4% N

Agriculture 3.2% om i na l

3.0% Professional Services Financials W a 2.8% g e G Information 2.6% rowth ( Health Care Leisure 2.4% 20 0 Manufacturing

2.2% 0 t o To d Wholesale & Retail 2.0% Construction Trade a 1.8% y) Transportation 1.6% -10% -8% -6% -4% -2% 0% 2% % Change in Union Membership (2000 to Today)

The pace of globalization accelerated after 1990 as technology helped the world become more integrated, allowing pools of capital and labor to come together efficiently. As borders became more porous, corporations increasingly shifted their operations abroad (often building at lower cost), outsourced a range of activities, and tapped into new, faster-growing foreign markets. This directly reduced the labor costs for producing goods and exerted a downward pressure on US workers’ wages. As shown below, this trend accelerated after 2001, when China joined the WTO, and has already started to flatten out.

World Nominal Exports (%GDP) Foreign Share of US Corporate Sales 35% 40% Financial crisis

35% 30%

30% 25% 25% China joins WTO 20% 20%

15% WTO founded 15%

Single European Act 10% 10% 60 70 80 90 00 10 20 60 70 80 90 00 10 20

A big part of this globalization wave was driven by developed world corporations tapping (directly and indirectly) into the cheap labor pool in China, allowing them to significantly reduce their net production costs. While some of this was passed on to consumers through lower goods prices, a big portion was retained by these companies in the form of higher profit margins. Over time, this cost differential has been eroded as the labor price in China has risen relative to that in the US. The measure shown below on the left captures labor costs adjusted for worker productivity, while the right-hand chart shows how much nominal wages have risen in China relative to those in the US.

Unit Labor Cost (Indexed to 2000) Relative Nominal Wages: China vs. US USA China USD, Indexed to 2000 2.25 8

2.00 7 6 1.75 5

1.50 4

3 1.25 2 1.00 1

0.75 0 00 05 10 15 20 00 05 10 15 20

© 2019 Bridgewater Associates, LP 5 Access to foreign markets has allowed US companies to both tap into the growing demand in these regions and to reduce costs as a result of cheaper labor and materials. The charts below compare the revenue growth and profit margins of US companies that have more sales exposure to foreign markets versus the ones that are more domestically focused. This highlights how companies that have higher exposure to faster-growing foreign markets have seen a stronger pace of revenue growth and a bigger improvement in profit margins. That said, the domestically oriented sectors and companies have also benefited (though to a lesser degree) from this globalization trend via lower input costs.

Non-Fin ex-Resources Sales Growth (1995–Today, Ann) Operating Margin 7% High Foreign Sales Low Foreign Sales 20% 6% 18%

5% 16% 14% 4% 12% 10% 3% 8% 2% 6% 4% 1% 2% 0% 0% Total Domestic Foreign 60 70 80 90 00 10 20

The next chart tries to more directly connect the change in margins to the change in the share of input costs that has been outsourced across manufacturing sectors, where we have good data from government reporting. Segments like computers, electrical equipment, and machinery, which have seen a larger increase in foreign-made content (e.g., moved abroad more to lower costs), have seen bigger increases in margins than segments like utilities and construction, which are still primarily domestically sourced.

Manufacturing Companies That O shored Production Improved Their Margins (10-Year Ending 2017) 250% Furniture Metal Manufacturing 200% % Change in Foreign Content

Primary Metals Electrical Equipment 150% Apparel 100% Auto Computers Mining Machinery 50%

Chemical products Utilities 0%

Food and Beverage -50% Oil and Gas Extraction Paper Products Construction -100% Wood Products -150% -150% -100% -50% 0% 50% 100% 150% 200% % Change in Margins

The charts below show some trends that are indicative of a gradual relaxation in policies that target firm concentration and competition and that have effectively allowed the formation of larger, more dominant firms. The chart on the right shows the share of pre-merger notifications that the FTC and DoJ (the two US merger enforcement agencies) flag for additional information requests, signaling an intent to pursue a deeper investigation. The share of transactions flagged in this way fluctuates on a year-over-year basis, but has been lower overall since 1995 than it was in the 15 years prior.

# of Annual DoJ Investigations by Type DoJ & FTC Second Requests for Info Competition Monopoly Mergers (% Eligible M&A Transactions) 600 5%

500 4%

400 3%

300 2% 200

1% 100

0 0% 70 80 90 00 10 20 1980-1995 1996-2017

© 2019 Bridgewater Associates, LP 7 We have seen a significant increase in the scale of merger activity after 1990, and the total number of publicly listed companies has shrunk. After declining in the 1980s and 1990s, firm concentration has picked up materially since 2000.

Mergers and Acquisitions (%GDP) 16

0 1910 1920 1930 1940 1950 1960 1970 1980 1990 2000 2010 2020

# of US Publicly Listed Companies USA Non-Fin Corp Concentration (HHI) 5,000 4,500 4,000 3,500 3,000 2,500 2,000 1,500 1,000 500 0 75 80 85 90 95 00 05 10 15 20 75 80 85 90 95 00 05 10 15 20

As a result, today the average US business is larger and more established. Now, US workers are more likely to work at a firm with more than 500 employees than they were in 1990.

Firm Age Breakdown (Years) % Employed at Firms by Size (# of Employees) 0 to 5 6 to 15 16+ <500 500+ 50% 60%

45% 55% 40%

35% 50%

30% 45% 25%

20% 40% 90 95 00 05 10 15 20 90 95 00 05 10 15 20

© 2019 Bridgewater Associates, LP 8 Rising sales concentration within a sector has shown a strong positive relationship with expanding margins, suggesting that greater pricing power comes from having more economies of scale, less head-to-head competition within a market, and overall higher bargaining power against labor.

Sector Change in Concentration vs. Change in Margins 7%

Tech C 6% han g e

5% i n M a Cyclical Services 4% r g i n s

( 20 0 Non-Cyclical 3%

Services 0–Today) Cyclical Goods 2% Non-Cyclical Goods Industrials 1%

Change in Concentration Index (2000–Today)

Scalability and Winner Takes All: Greater Scalability and Winner-Takes-All Dynamics Have Further Supported the Rise of Larger, More Dominant Firms and Margin Resilience

Another major shift over the past few decades that has helped firms increase and maintain their high profit margins is the ability for large firms to scale up their operations without raising costs by as much, and that high operating leverage and sheer scale have contributed to “winner-takes-all” dynamics in many sectors. In many ways, with the changing nature of the overall economy and demand, the secular shift away from tangible investments—like physical equipment and buildings—and toward intangible investments—like intellectual property, including software and patents, for example—has facilitated the production and consumption of these scalable products (e.g., software) and has helped these companies build a “moat” (increasing barriers to entry for new entrants). The left-hand chart below shows how the share of intangible investments of companies in the US, Europe, and Japan has risen secularly. The chart on the right breaks down the various forms intangible investment can take, from software investment to economic competencies (which include management improvements, organizational design, marketing, and the like) to innovation property (including patents, research and development, etc.).

Big Three Economies’ Tangible and Intangible Investments (%GDP) Intangible Investments by Sector (%GDP) Intangible Tangible Software Innovation Property Economic Competencies 14% 4% 13% 12% 3% 11% 10% 9% 2% 8% 7% 1% 6% 5% 4% 0% 95 98 01 04 07 10 13 16 19 Tech Biotech Retail Financials Resources Utilities & Manuf © 2019 Bridgewater Associates, LP 9 It is interesting to see the relationship between the growth in intangible investments at the sector level and the increase in sectors’ profit margins over the past 20 years. This is not meant to suggest that this force is by any means the dominant driver of the margin changes, but rather how a number of forces (such as this one) have all come together to support the profit margins of particular sectors, like information technology.

Change in Intangible Investment vs. Change in Margins 7% 6% Information C han g Management Services 5% e i Agriculture 4% n M a Manufacturing 3% r g

Transportation i 2% n s

Other Accommodation ( 1

Arts 99 8–Today) 1% Wholesale Trade Professional Services 0% Construction -1% Utilities -2% -3% -2% -1% 0% 1% 2% 3% 4% 5% 6% Change in Intangible Investment (% Sales, 1998–Today)

The impact from a continued shift toward automation is one more such force that supports corporate profits. While at this point it is hard to quantify its impact, it could have a more material impact in the future. There are early signs of companies in a broad range of industries purchasing more industrial robots in recent years as costs of robots have gone down, while a few sectors (autos and electronics) have seen a larger adoption so far.

Industrial Robots by Industry (Thousands) Industrial Robot Cost Decline (Unit Cost USD, Thousands) 2015 2016 2017 $160 140 $140 120 $120 100 $100 80 $80 60 $60 40 $40 20 $20 0 $0 Autos Tech Machines Plastic & Food Other Chemicals 95 00 05 10 15 20 25 Source: International Federation of Robotics Source: ARK Investment Management, LLC

Though only a few sectors have implemented automation in a large way so far, the table below shows how several sectors have the potential to be meaningfully impacted as costs come down and adoption becomes more widespread. The measures shown below assess how often workers across sectors are required to perform different skills, and assess how automatable those skills are with the technology currently available to determine how automatable the hours worked in each sector are overall.

Automation Managing Applying Stakeholder Unpredictable Data Data Predictable Sector Potential Others Expertise Interactions Physical Work Collection Processing Physical Work Accomodation and 73% 2% 4% 22% 5% 8% 10% 48% food services Manufacturing 60% 5% 13% 8% 8% 22% 11% 33%

Agriculture 60% 3% 5% 7% 51% 11% 9% 13% Transportation and 57% 4% 8% 14% 14% 22% 14% 24% warehousing Retail trade 53% 3% 6% 26% 5% 15% 28% 17%

Mining 51% 7% 11% 8% 24% 21% 12% 17%

Other services 49% 7% 12% 17% 13% 15% 11% 25%

Construction 47% 5% 10% 8% 41% 15% 11% 10%

Utilities 44% 7% 14% 13% 19% 23% 13% 12%

Wholesale trade 44% 5% 12% 24% 11% 17% 19% 12%

Finance and insurance 43% 6% 19% 23% 0% 16% 34% 3% Arts, entertainment, 41% 10% 13% 24% 15% 13% 11% 14% and recreation Real estate 40% 7% 12% 21% 19% 16% 17% 8%

Administrative 39% 6% 13% 14% 23% 21% 13% 10% Health care and 36% 8% 14% 14% 11% 20% 13% 21% social assistance Information 36% 5% 25% 20% 7% 16% 20% 6%

Professionals 35% 7% 27% 16% 2% 19% 23% 5%

Management 35% 10% 25% 16% 3% 17% 24% 5%

Educational services 27% 22% 29% 10% 8% 13% 10% 7% **% of time spent on activities that could be automated by adapting current technology Source: McKinsey & Company

Over the last four decades, corporate tax policy has consistently favored business, and as a result the effective rate has fallen from 45% to about 20%. The effective tax rate that companies pay is now at all-time lows from a combination of declining statutory rates and the use of loopholes that lower the rate companies actually pay on their earnings. The chart below summarizes a number of the key actions that led to the decline in effective US corporate tax rates over the last 40 years.

US Listed Companies Eective Tax Rate 60% Reagan tax cut I Bush II tax cut Carter tax cut Reagan tax cut II 50% Obama stimulus

40% Trump tax cut

Achieved through a combination of 30% lower statutory rates, tax deductions for investments, and tax arbitrage 20%

10% 1960 1970 1980 1990 2000 2010 2020

One of the long-standing arbitrages that companies took advantage of was their ability to book foreign revenues offshore while booking very few operational costs there. This was particularly beneficial for companies with large amounts of intellectual property (e.g., tech, pharma), which could seamlessly move assets offshore.

US Corp Foreign Aliates US Corp Foreign Aliates % Proﬁts Booked in Non-Tax Haven Aliates % Wages Booked in Tax Haven % Proﬁts Booked in Tax Haven Aliates % Wages Booked in Non-Tax Haven 100% 100%

80% 80%

60% 60%

40% 40%

20% 20%

0% 0% 65 75 85 95 05 15 65 75 85 95 05 15

Looking ahead, some of the forces that supported margins over the last 20 years are unlikely to provide a continued boost. Incentives for offshore production have been reduced as global labor costs have moved closer to equilibrium, with domestic costs and rising trade conflict increasing the risk of offshoring, while the potential tax rate arbitrage from moving abroad is now much smaller.

Deloitte Competitiveness Survey Global Tit-for-Tat Gauge China US

US less competitive Close to parity 110%

100%

90%

80%

70%

60%

50% 2012 2016 Jan-17 Jul-17 Jan-18 Jul-18 Jan-19

At the same time, we have seen popular sentiment begin to sour against the forces that have driven margin expansion, as well as against the companies that have benefited most from them. As we have discussed at length in prior research papers, we are in the midst of a populist backlash against rising inequality and increasingly seeing a move toward more protectionism. Recent surveys show increasing animosity toward globalization and the power of companies more broadly and a bit more welcoming attitudes toward government regulation of firms.

04 06 08 10 12 14 16

% Report Being “Very Dissatisﬁed” Perception of US Government Regulation of Business with Power of Major Corporations Too Much Too Little Right Amount 50% 55%

45% 50%

40% 45%

35% 40%

30% 35%

25% 30%

20% 25%

15% 20%

10% 15% 00 05 10 15 20 00 05 10 15 20 Source: Gallup Source: Gallup

Furthermore, we have recently seen an increase in the discussion on taxing mega-profitable firms that have benefited from current policy. Below, we list some of the measures around taxing and regulating superstar tech firms being discussed globally. For example, Europe’s potential “digital services tax” is explicitly designed to close the tax arbitrage (by introducing a sales tax on online revenues from residents). While the current impact of these proposed rules on the overall profitability of these tech giants is relatively small, they are a straw in the wind that the tide might be turning and that the multi-decade boost from favorable taxation policies is unlikely to be repeated.

Theme Specific Action Companies Affected Country/Region

Taxation Digital Service Tax on Revenue All Tech Europe Ebay, Amazon, Taxation Online Platforms Liable for Collection of Local Taxes Germany AirBnB Hate Speech/ Platform Legal Liability for Hate Speech All Tech Germany, UK National Security Property Rights Platform Legal Liability for Copyright Violation All Tech Europe Data Protection Restrictions on Monetization of Data All Tech Europe Privacy Monopoly Power Abuse of Platform Power All Tech Europe E-Commerce Platforms Restricted to Marketplace Platform Neutrality Amazon, Walmart India Facilitation Only (Can’t Sell Own Products/Favor Products)

© 2019 Bridgewater Associates, LP 14 While there is no precision to when and how much each of the factors described above will weigh on profit margins and how much can be offset (for example by automation picking up), it will be hard for companies to maintain the current level of profitability over the coming decade, let alone increase the margins further from here.

© 2019 Bridgewater Associates, LP 15 This research paper is prepared by and is the property of Bridgewater Associates, LP and is circulated for informational and educational purposes only. There is no consideration given to the specific investment needs, objectives or tolerances of any of the recipients. Additionally, Bridgewater’s actual investment positions may, and often will, vary from its conclusions discussed herein based on any number of factors, such as client investment restrictions, portfolio rebalancing and transactions costs, among others. Recipients should consult their own advisors, including tax advisors, before making any investment decision. This report is not an offer to sell or the solicitation of an offer to buy the securities or other instruments mentioned.

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