Globalisation, low corporate taxation, low financing costs and ‘winner takes all’ sector concentration in areas such as IT have created a halcyon era of profitability. However, this era is under severe threat due to fundamental challenges in the form of increasing competition and labour costs. We have been here before, notably in 2002 and 2009, when profits went on to recover. Will this time be different?
Profits decline, wages rise (from 31 Jan 1996 to 26 Jul 2016)
At first glance, some of the recent decline in profitability in the US could be passed off as transient. A stronger US dollar, for example, has been hurting exporters. However, with the Fed more likely to tighten than loosen monetary policy, US dollar strength may be a more persistent issue. Another culprit has been falling energy prices, which have hit associated companies’ current and prospective earnings. A rebound in oil prices this year has many hoping that this, too, will be a transient phenomenon. But as supply disruption eases in places such as Nigeria, and Iran re-enters the market, the knock-out effect of falling rig counts in the US may fade. Recovering prices also lead to production being swiftly ramped up to take advantage of the stronger market, resulting in self-limiting gains. As such, it is not clear that oil will maintain its pace of recovery from here.
Corporate profitability could face more fundamental challenges in the form of increasing competition and labour costs. Concentration in many industries has seen super-normal profits for many firms. Following the ‘Big 3’ car manufacturers in the 1950s and finance in the 1990s, recently it has been the turn of IT with the likes of Google, Facebook and Netflix dominating the industry.
Competition is likely to intensify as emerging markets start to produce world-beating firms and smaller unlisted companies leverage technology platforms to offer their services to a wider audience. Furthermore, the high levels of industry concentration that often accompany eras of high profitability have already gained the attention of antitrust authorities. The US Department of Justice has recently demonstrated an increasingly robust approach to the deal-making that companies seek out in order to generate better margins. In April, a merger between Halliburton and Baker Hughes was blocked, while the proposed Office Depot and Staples tie-up met a similar fate in May. While the outcome of the US election remains highly uncertain, in the event of a Hillary Clinton presidency we may see an even more robust antitrust stance.
Labour costs are another issue. In the US, hourly wages have increased by 2.5% on the previous year, while the Employment Cost Index has picked up from its end-2009 low. More gains are likely to come from two directions. First, the labour market is tightening, particularly if the low number of applicants-to-job openings is any indicator. Second, the presidential campaign in the US is at its heart about the declining state of real median incomes over the last decade or so, with the remaining candidates implicitly suggesting different ways to reverse the tide. Whatever the drivers, rising wages present a particular challenge in a low productivity world as unit labour costs tend to depress corporate margins.
Elevated valuations and falling profits logically suggest subdued future equity returns. However, the asset class still looks more attractive than 30-year Treasury bonds.
The decline in profits comes at a difficult time for equity markets which already face a slew of headwinds, not least elevated valuations and political uncertainty. This suggests an era of lower returns than investors have historically come to expect.
However, investors can draw some comfort from the fact that, in the short term at least, the financial authorities appear willing to provide support when markets lose confidence. There will also be opportunities for significant outperformance at the sector and stock level where genuine innovation is successfully researched and identified.