The sweet spot for US corporate margin expansion and profits growth ended several years ago, mainly in response to an exhaustion of cyclical productivity surprise and associated unit cost reduction.
Looking forward, the base case is that margins will drift roughly sideways, at least outside energy, for as long as aggregate demand growth runs at a slightly-above-trend pace. Once growth cools to trend, margins should begin to erode slightly, and they seem likely to do their usual face plant during the next recession – or at least early stage of it. This is an important and likely enduring headwind impeding prospective gains in the equity market.
However, there is a stronger-form version of profit-related equity market bearishness that I would like to address – and hopefully undermine – in this report. In the wake of some fairly dramatic downward revisions to the National Income and Product Account (NIPA) measures of US profits, many economists and strategists have begun to worry aloud about the following two points.
First, the weaker NIPA profits may imply that index-level earnings may be significantly overstated.
Second, a nascent trend toward profit margin compression may imply that we are in the late stages of the business cycle expansion, not just measured as the integral of excess growth under the curve but measured also in time. If that is the case, then risk premia may be about to pop as well.
In an earlier report back in September, I addressed the comparison of NIPA with index-level earnings and found the strong-form bearish take overstated.
In this report, I update that first point and add three to it. First, the bears are looking at the wrong definition of global profits. Their preferred concept presumably overlays most closely with the reported earnings that make their way, indirectly, into the index data. But in the current environment that is a flaw, not a feature.
Second, the conventional take on the NIPA margins data is probably wrong because it fails to account for transfer pricing distortions holding down domestic margins and because it somewhat glibly assumes that a shift of national income from corporations to households must be dangerous to the expansion. That latter fits the historical data but may not apply today. It resembles the recent drama around the yield curve in that regard.
Finally, definitional and conceptual issues aside, I suspect (without knowing yet) that even the global NIPA profits data may be understated or at least quite misleading in the current context. In this report I raise a question without answering it. I will have more on that later.
None of the points I raise here are themselves decisive taken in isolation. But the cumulative effect is to reinforce my skepticism around the strong-form bearish take on recently weaker NIPA profits. The main threats to the bull market would seem to be elsewhere.