Why the Sudden Volatility?

Corporate America has enjoyed an operating environment very supportive of profit growth for the past several years. In fact, earnings for the companies in the S&P 500 are up about 150% since the year the Great Recession ended (2009), which translate to an annualized growth rate 11%. But perhaps it’s more instructive to the evaluate the growth rate in earnings since the pre-recession peak so we can see how it stacks up to history. It turns out that during the eleven year period from 2007 to 2018, S&P 500 earnings grew at an annualized rate of about 5.5% – very close to the average over the past 100 years or so. Think about that. The rebound in corporate earnings over just a nine-year period has been so powerful that it’s almost like the largest economic downturn since the Great Depression never happened. For all the talk of the anemic pace of this economic recovery, the pace of recovery in corporate earnings has been nothing short of miraculous!

Of course, the growth in corporate earnings since 2009 has not come from top-line gains so much as margin expansion. In other words, the majority of profit growth can be attributed to companies squeezing more profit out of each dollar of sales rather than actual increases in sales. There were a confluence of factors that drove margin expansion during the recovery. And just when it looked like margins were set to peak, Corporate America was given a gift that keeps on giving: a cut in the corporate tax rate along with other pro-business tax relief initiatives. But here’s the problem. Even as lower taxes will continue to support after-tax margins, pre-tax (or operating) margins may finally start to come under pressure as several favorable trends are beginning to reverse.

Source: Bloomberg
 
 

What are the factors that are weighing on corporate margins?
  • Now that the unemployment rate has dropped below 4%, wages are beginning to rise at a faster rate. Continued labor shortages could accelerate the wage gains.
  • While energy prices have pulled back in recent days, the price of oil is still up quite a bit in recent months
  • Transportation/freight/shipping costs have been rising fairly rapidly due to a shortage of truck drivers (as well as higher fuel prices)
  • Newly implemented tariffs have led to increases in input/commodity costs, like steel
  • Debt services costs are rising due to continued Fed rate hikes and a surge in corporate debt (much of which was used to buy back stock)
  • Economic growth has slowed fairly dramatically outside the US, with China posting its slowest growth rate (6.5%) since the Financial Crisis. Slower growth outside the US reduces demand for US multinationals’ exports
  • The dollar has increased in value as the Fed continues to hike rates and US growth continues to outpace many other regions of the world; a stronger dollar makes US companies less competitive vis a vis their non-US competition
  • Flush with the tax-cut windfall, many are speculating that some of these benefits might get “competed away” as companies lower prices in an effort to drive market share gains
In an ideal world, companies would be able to pass the rising cost of production on to consumers through price increases. But there are two problems with this scenario. The first is that, despite what many management teams might be saying, rising prices are likely to affect demand in a negative way. That’s just Econ 101. And lower demand could lead to lower sales, which can cause negative operating leverage and further decreases in margins. The second is that rising prices, especially on consumer goods and services, could cause the Fed to increase interest rates at a quicker pace. Yes, we have heard the argument that the Fed might be inclined to “look through” any transitory increase in inflation resulting from the a trade war with China. But tariffs and the associated inflation are only one source of cost pressures for US companies. If the Fed senses a sustained increase in inflationary pressures, the tightening process will accelerate and put the brakes on economic growth.
It’s not that earnings growth is expected to go into negative territory anytime soon. In fact, analysts continue to forecast S&P 500 earnings growth of 10% in 2019 following 22% growth in 2018 (which was goosed by the tax cut). Rather, it’s the rate of change that investors care about. Is it possible that the growth deceleration could be even greater than expected next year? What happens if earnings growth is only 5%? From where I sit, it seems like the stock prices had already been discounting that 10% rate of increase. As Soul II Soul sang in 1989, it’s “back to life, back to reality.”
If margin pressure weren’t enough, investors now must contend with several ancillary risks. Whether it be the intensifying trade war with China, the impending mid-term elections, the Honduran refugee crisis, Brexit, the Saudi Arabian scandal, the Fed uncertainty under a new Chairman, the sharp stock market drop in China and the other EMs, or the Italian debt crisis – there is plenty for investors to worry about!
The takeaway from all this? Earnings estimates for 2019 are probably too high and need to come down, perhaps significantly. In our view, a resetting of expectations was inevitable at some point. There had been far too much investor complacency over the past couple of quarters.   The good news is that periodic corrections are healthy. As this process unfolds, it is likely that opportunities to establish or increase positions will arise – opportunities that had been in short supply over the past couple of years.