We believe global economic activity should slow this year to a level closer to potential growth rates. What does this mean for corporate profits and margins, especially as the U.S. enters the final phase of its expansion?
The deceleration in economic growth casts a shadow on corporate profit margins, we write in our new Macro and market perspectives Profit margins under pressure. Potential margin compression and slower gross domestic product (GDP) growth could compound this year into a full-blown U.S.-led global earnings recession – typically defined as two straight quarters of annual declines in earnings.
Some of the decline is explained by the unfavorable base effects from last year’s U.S. corporate tax cuts. Yet other macro factors also suggest that U.S. profit margins are likely to contract over the course of 2019.
As the fourth quarter 2018 earnings season closes, some top-down earnings forecasts for 2019 have been revised to stall-speed – especially in the U.S. relative to Europe – even as bottom-up estimates and consensus forecasts remain more upbeat. Top-down forecasts look at aggregate macro data related to profits and margins, while bottom-up estimates focus on aggregated data about individual companies and sectors.
A two-way feedback loop
The late-cycle compression in margins limits inflationary pressures and allows central banks to be patient in their policy normalization. But falling profitability also reduces incentives to invest and to hire. The two-way feedback loop between the cycle and margins suggests there will be a fall in margins this year and potentially an outright earnings recession, in our view. Current consensus estimates appear too high, potentially leaving both equity valuations and credit markets exposed.
Analyzing the cyclical behavior of U.S. profit margins is complicated by the secular rise in margins since the 1980s. We therefore need to disentangle this trend increase from the cyclical swings. The chart below on the left shows our estimate of U.S. corporate pre-tax profit margins based on national accounts data (NIPA).
The cyclical pattern is clear – and also applies to earnings. Since the late 1980s, profit margins have contracted sharply in the late-cycle phase highlighted in orange above, snapping the mid-cycle expansions. Margins typically trough in a recession and hover sideways early cycle.
An unusual expansion
But the current extended expansion does not appear to be following the same template. Margins expanded in the early phase, followed by a mid-cycle drop in margins – driven by the China, energy and U.S. dollar shocks of 2015-2016. Margins picked up again at the start of 2018. This underscores how the recovery from the global financial crisis has been unusual in many respects – and there is no reason why it should not be different for margins, too. Profit margins have been boosted over time due to secular trends such as globalization and increased industry concentration.
By adjusting for these long-term shifts we can see more clearly their cyclical swings. The chart above on the right shows the spread of margins in percentage points relative to their long-term trend. Viewed this way, profit margins look soft in this phase of the cycle.
We believe margins have likely peaked and expect a material contraction in 2019 – a typical late-cycle pattern, we find.