Despite some strength in recent sessions, it seems as though the stock market is caught in a funk. Volatility is up sharply, and the major market indices remain well below the all-time highs set earlier this year. This sea change in the markets has confounded a lot of investors as the economy seems to be growing at a reasonable pace, consumer and business confidence is hovering at very lofty levels, and corporate profits are expected to grow at a rapid clip both this year and next. In fact, analysts expect the companies in the S&P 500 to post 20% earnings growth this year (with the help of tax cuts) followed by another 10% next year. What could investors be so worried about?
When the Tax Cuts and Jobs Act was passed late last year, investors were acting quite rationally as they bid stocks up to new highs. US companies would finally be on a more level playing field with foreign competitors, and the tax savings (in the form of both lower rates and accelerated depreciation) would provide the resources necessary to invest for continued growth. But in more recent months investors are increasingly coming to two sobering conclusions. First, the markets had already priced in a good portion of the tax-cut benefits. The S&P 500 rose nearly 20% in 2017 on top of the massive gains since the lows of the Great Recession. Secondly, investors are also coming to the realization that there will be some powerful offsets to lower taxes as we enter the late stages of the economic cycle. For instance, how much of the tax savings will get passed on to workers in the form of higher wages and benefits? How much will go to cover the rising cost of energy and raw materials? How much will be lost to the rising cost of debt servicing as interest rates rise? How much of the profits will be deferred as companies reinvest in future growth? And perhaps most importantly, how much of the tax savings will get competed away (or passed on to customers in an effort to maintain or grow market share) over time?
The chart below shows that corporate operating margins have been running at historically high levels in recent years. Corporate margins have benefited from a number of tailwinds, including huge slack in the labor market (which translates to low wage growth), relatively low commodity prices, deferred investments, low debt servicing costs (interest rates) and a weaker dollar. As we discuss below, these tailwinds have been turning into headwinds. I would also note that, although it does not show up in the operating margin, most companies have been able to boost earnings-per-share (EPS) by buying back loads of their stock. At today’s sharply higher stock prices, any future buybacks will be far less accretive to EPS.
Corporations have added a lot of debt to their balance sheets over the past several years as investors have rewarded companies that were willing to borrow in order to finance share repurchases. In the chart below, you can see that Non-Financial Business Debt is approaching $14 trillion – well above the levels preceding the Financial Crisis. As interest rates rise, many companies will find that servicing their debt could become rather onerous. In a worst case scenario, some companies may find they are unable to refinance maturing debt at affordable rates. At the very least, rising interest costs will weigh on corporate profitability.
Source: Federal Reserve
Labor costs have been remarkably well contained during this economic expansion as the ranks of the unemployed have been put back to work. As it currently stands, there is much disagreement about how fast labor costs will rise going forward now that the unemployment rate has been reduced to 3.9%. Some believe significant slack remains as better job opportunities will encourage folks to rejoin the labor force. If so, this would argue for wage growth that is more contained. Others believe that companies are having a very hard time finding qualified candidates to fill vacate positions and must therefore raise wages at a more rapid clip. Either way, it is pretty clear that labor costs will be increasing at a faster clip than the recent past.
Source: Bureau of Labor Statistics
The benefits from low energy and other commodity costs seem to be waning as well. The chart below shows that commodity costs are on the rise, and these increases will clearly weigh on corporate profitability unless companies are able to pass on the increases to their customers. It should also be stated that higher debt service costs and rising commodity prices will also put pressure on consumers, who represent much of the demand for the products and services that US companies sell. As a result, many companies are finding they are not able to pass on input-cost increases without materially affecting demand.
A falling dollar was a big tailwind for US multinational companies in 2017. A lower dollar makes exports more competitive in the global marketplace while also making it harder for foreign importers to compete in the US. As can be seen in the chart below, the dollar has begun to rise again. The increase reflects stronger economic growth vis a vis the rest of the world as well as the Fed’s ongoing removal of policy accommodation (increasing interest rates). If the dollar strength continues, we can probably start to expect guidance reductions from US multinationals.
The bottom line is that corporate margins are coming under pressure, and these pressures are starting to become better appreciated among the investing public. With lofty earnings expectations ahead, the onus is now on corporations to show they can hit the estimates in spite of these margin pressures. In our view, this will require better top-line growth, and strong evidence of better revenue growth is still lacking. Accordingly, it’s probably best to take Wall Street analysts’ earnings estimates with a grain of salt for now.