John Chisholm (pictured), executive vice president and CIO at Acadian Asset Management, argues that the evolution of profit drivers and other factors, such as valuation, over the next decade will put pressure on cap weighted equity returns.
Corporate profitability in the US has been unusually elevated over the past ten years relative to the entire post-World War II era. The question of whether profit margins will remain elevated should be of keen interest to investors, as the impact of corporate profits on equity market returns going forward could be significant.
Corporate profits are growing even as GDP slows
Real US GDP growth has fallen significantly over time. From a compound annual growth rate of 3.9% from 1950 to 1975, and 3.4% from 1976-1999, the most recent period from 2000 to 2014 has seen real GDP grow at just 1.9%. In contrast, corporate profitability has significantly risen over these periods, from 2.7% annualized during 1950-1975, to 4.0% from 1976-1999, to 4.5% for the most recent 2000-2014 timeframe.
Figure 1: US GDP Growth and Profits, 1950-2014
Source: US Bureau of Economic Analysis.
Corporate profits in the US are close to a record high, even when adjusted for variables such as changes in inventory valuation, inflation, depreciation, and the imputed value of real estate.
Figure 2: US Profit Margins – High Even When Adjusted, 1947 – 2014
Y-axis: Profit Margin (%)
Source: Acadian Asset Management LLC calculations, US Bureau of Economic Analysis, the National Bureau of Economic Research. Corporate profit after tax with inventory valuation and capital consumption adjustments (in billions of dollars) relative to nominal gross domestic product for the US from 1947 to 2014. For illustrative purposes only.
This historically high level of profitability is especially true for large, publically traded companies. US profit margins based on the S&P 500, for example, are at the 95th percentile of their past twenty-year history.
Figure 3: US Profit Margins – Based on S&P 500, 1993 – 2015
Y-axis: Profit Margin (%)
Source: Acadian Asset Management LLC, S&P 500, Worldscope.
Why margins in recent years have increased
What factors are driving this profit upturn in the US? Over the past decade, corporations around the developed world have seen a positive bottom-line impact from several key shifts. Some are powerful structural forces that are very likely to persist. They include well recognized trends arising from the globalization of the labor force and downward wage pressure from emerging labor pools in China and elsewhere. This has driven a decline in the share of output to labor and a drop in the relative price of investment goods.
The most important recent factors for the US, however, have been declining interest expenses, changes in operating margins, and declining effective tax rates. The chart below decomposes the change in 2014 US profit margins from the longer-term average, a difference of 3.1%. Of this, the majority (2.5%) is from lower interest expenses, the salient feature of the post-GFC global economy. Operating margins are another significant contributor at 0.7%. Margins were also helped by a significantly lower effective tax rate, as corporations engaged in international tax arbitrage and other tax-lowering strategies. This appears as a negative contribution at -0.2%, but is actually a positive relative to the -0.6% impact that would have been felt under the tax conditions of the earlier period.
Figure 4a: Margin Decomposition: US
Y-axis: Margin (%)
Figure 4b: Explanation for the Impact of Lower Effective Tax Rate for 2014 Net Profit Margin
Source (Figures 4a and 4b): Acadian Worldscope data.
Expectations about the future path of US profitability
What does the future hold? Are we likely to see margins mean revert from these near-peak postwar levels in the US? While some of the forces behind elevated US profitability are unlikely to abate, it seems reasonable to expect that going forward, a number of factors that have been supportive of US profit margins may reverse in the years ahead.
It is clear that the US is moving to a higher interest rate environment, which will directly raise the cost of capital for corporations. We believe the rate hikes will be gradual, but this will not change the reckoning on corporate balance sheets.
While wage inflation has been relatively stable at around 2% during most of the current US recovery, there are signs that this could be about to pick up, as suggested by job openings and their correlation with wage inflation. Pressures to raise minimum wage levels and evidence of shortages of skilled labor (as reflected in small business survey comments about difficulty in finding qualified workers) also point to the likelihood of accelerated wage growth in the US
Other trends include a recent increase in worker activism, changing demographics and shortages of skilled workers in a number of industries, lower productivity growth, increases in effective tax rates, and the persistent strength of the trade-weighted dollar. Some combination of these forces means we are likely to see some gradual mean reversion of corporate profitability in the US in the years ahead.
The importance of corporate profits for equity returns
Why should equity investors be paying close attention to the future profitability landscape? We believe it has significant implications for future equity returns. The link between profit margins, GDP growth and equity market returns has been well established in classic research by John Bogle, Richard Grinold, Roger Ibbotson and others.2 There are a number of formulas that have been suggested for calculating the relative contribution of GDP growth, earnings growth, profitability, valuation, and other factors to equity returns. Of these, the one presented below is among the more granular, breaking out corporate profits from broader measures of economic growth:
R = Dividend Yield + Real GDP Growth + Inflation + Change in Corporate Profitability + Change in PE Ratio
Using this formula, we can see that the composition of historical US equity returns has changed from period to period. In the most recent timeframe, corporate profitability has been far more dominant than we have seen over the longer term. Without it, S&P 500 returns over the past fifteen years would have been significantly lower—in fact, cut by half.
Figure 5: S&P 500 Historical Return Decomposition, 1950-2014
Y-axis: Annualized Return (%)
Source: Acadian Asset Management LLC, S&P 500.
What does this imply for the future? The chart below shows the impact of changes in margins on potential US equity returns under various valuation and growth scenarios. This data suggests that even if profit margins stay elevated relative to history, US equity market gains over the next five to ten years are likely to be low. It is difficult to imagine that US stocks will perform as they have historically unless there is a significant resurgence of economic growth. Given the cyclical and structural impediments currently at play in the US and global economy, it does not seem likely that the current upturn will reach the levels needed to boost US equities out of the lower trajectories shown on the chart.
Moreover, US corporate profit margins have recently been at about 9-10%. Even a small drop, perhaps to 8%, suggests low single-digit annualized returns for the US equity market over the next decade. If this is combined with low economic growth and/or lower P/E values, returns could be zero or even negative.
Countering this scenario, a surge in economic growth or a significant increase in equity valuations could bring US equity returns into line with long-term averages. This appears to be a less likely outcome, however, given the conditions currently in place.
Figure 6: Sensitivity of Equity Returns to Margin Changes: 1.0% – 2.0% RGDP Growth, 2016-2025
Y-axis: S&P 500 Annualized Return (%)
X-axis: Profit Margin in 2025
Source: Acadian Asset Management LLC, S&P 500. Assumptions include 1% annualized CPI through 2025.
The view outside the US
Given the tepid outlook for US returns, a natural question is whether we see a similar picture in other global equity markets. Outside of the US, the picture is a bit better.
Profit margins in Germany and the UK are elevated, though not stretched to historic highs. Interest rates have been positive for Germany, while lower taxes appear to be a more significant driver in the UK However, growth in profits for both countries has been constrained by other effects, including a negative contribution from operating margins in the UK and from industrial structure (sector composition) in Germany. Other European markets, including France, Italy, Spain, and the Netherlands are at median or low levels of profitability relative to history.
The outlook for corporate profit margins in Europe will depend on a range of factors, including interest rate changes, taxes, currency exchange rates, and revenue growth. As an overall observation, the prospects appear good for sustained and in some cases increasing profit margins over the next few years. The European Central Bank has been in a stance of monetary ease, and this is not likely to be reversed while inflation rates and the overall pace of economic activity remain subdued. Major changes in tax rates and fiscal policy regimes are not currently foreseen, and the decline in the exchange rate of the euro versus the US dollar will benefit export-oriented companies with major revenues in dollars or currencies linked to the USD. Revenue growth will be impacted, of course, by underlying economic growth in Europe and in the global economy. Intermediate-term prospects appear subdued but may improve if global oil prices remain lower for longer, as now seems to be a viable forecast. Reduced energy costs act effectively as a tax cut for consumption and would be a net positive even after accounting for specific sector effects such as the effect of lower oil and gas prices on the profits of energy companies.
Japan profit margins, while high relative to its own history, are at moderate levels—about half those of the US Japan is a distinct case, where historically profitability has been much lower than in other developed countries. However, over the last couple of years, the sharp decline in the yen exchange rate and an increased focus on corporate governance and shareholder returns have driven profitability to levels unprecedented in Japanese history. The introduction in 2014 of the JPX-Nikkei 400, a profitability- and capital efficiency-based benchmark, signals the growing importance of these measures to Japanese investors and corporations. The Government Pension Investment Fund’s move to this new index as it reduces bonds and reinvests heavily in equities is widely seen to be generating pressure on companies to groom their profitability for inclusion in the index. With Japanese corporate profitability levels well below those of the US, a continued emphasis on investor returns and productivity of capital could be a significant factor in the attractiveness of Japanese equities over the longer term.
In short, mean reversion in corporate profits seems most likely to occur in the US rather than in Japan or Europe, and even in the US appears likely to be gradual rather than abrupt.
Conclusion and potential implications for asset allocation
This discussion of corporate profitability and market returns suggests the following conclusions:
- Corporate profit margins are a key driver of future equity rates of return. Erosion of profit margins in the US could have a significant impact on US equity returns relative to expectations over the next decade. Investors and fund sponsors should have realistic and muted expectations of US equity rates of return, based on the prospects for major capitalization-weighted indices.
- The US equity market is broad and offers diverse valuations and potential return prospects, so active management could produce outcomes that are meaningfully better than those from passive cap-weighted benchmarks. The analysis in this paper is based on aggregate market data. When the returns to beta are expected to be low, skill-based excess returns could be a bigger part of total returns for asset owners.
- Investors would be well served to pursue a range of global portfolio diversification strategies that seek to enhance returns and potentially lower risks. The potential for improved corporate profitability among developed economies appears higher in Europe and Japan.