Equities have sold off while companies are making record margins. Should we buy?
The first six months of 2022 were traumatic for investors. Just as the global economy was rebounding from the Covid-19 pandemic, Russia’s invasion of Ukraine in February sowed chaos through financial and commodity markets. It raised risk premia and sharply exacerbated the existing inflationary pressure of a global recovery while supply chains were still recovering from the pandemic.
- Earnings, the key driver of long term equity returns, are the product of revenue and margins
- Margins are cyclical and trend-reverting, but currently at record levels in developed markets helped by pandemic-related excess stimulus
- Forward-looking economic indicators are weakening and margins are at risk of a material decline
- Even after a significant pullback this year, equity markets do not appear to have priced in a material drop in profit margins. Equities are therefore more expensive than they look. We remain cautious
Two decades of central bank activism have taught investors to buy the dip, but there is no ‘Fed put’ this time. On the contrary, central banks are actively tightening to subdue inflationary pressures not seen in developed economies since the 1970s. At the same time, Western governments defied expectations with the speed, unity and severity of the sanctions they imposed on Russia, changing the cost of the world’s food and energy in the process. Oil spiked by a third to $120/barrel while the price of wheat blew out 50%, reflecting Ukraine’s status as a major producer.
Last year’s debate on the character of inflation has been settled in favour of the ‘persistent’ camp, and central banks are doing what they can with a limited array of tools. Policy rates are a blunt instrument to manage aggregate demand at the best of times, but are particularly inadequate when dealing with supply-side inflation.
The result of all this was increased volatility across most asset classes and a notable correlation between the world’s most liquid assets: equities and bonds. Historically, increased downside correlation, where equities and bonds fall at the same time, has occurred when inflation has been both high and volatile, a scenario unknown to most investors today. If inflation remains elevated, we expect more volatility in risk assets as investors grapple with this new macro framework. We have seen some of the worst first half returns for equities and bonds in many decades, but there may be more to come.
Successful investors know that times of stress produce opportunities. When emotions are running high they stick to fundamentals to identify bargains for the next upcycle. Our colleague Boipelo Moyo wrote a very insightful piece recently, looking at the historical pattern for equity market pullbacks around economic recessions, read more here. We use this research as one of many factors in contextualizing this year’s drawdown in equity markets.
In addition, we are going to examine more deeply one of the fundamental drivers of equity markets: corporate earnings.
Earnings drive equities in the long run
The theoretical value of any asset is the present value of the future cashflows it will generate, discounted at a rate which rewards investors for the risk they are taking. Similarly, the value of any individual equity (or stock market) can be understood as a multiple of its future earnings: the stream of earnings is what you ‘get’, the multiple is what you pay for it. As the following chart illustrates, price oscillates around earnings as multiples expand and contract, reflecting changes in investors’ mood as they peer into an uncertain future. Multiples and discount rates are volatile and behavioural but underlying earnings and cashflows are a real-world phenomenon that we can interrogate. A view of the sustainability of current and forecast earnings is critical to any useful equity market outlook.
Net profit margins at record levels
In simple terms, a company’s ability to deliver earnings begins with its ability to generate revenue. At a macro-economic level, revenue is synonymous with GDP, which captures the value of all transactions in the economy (see the Appendix for comparisons of revenue and GDP growth for the world and US). The relationship between the revenue of listed companies and nominal GDP is tightest at the overall global level, but less so on an individual country basis, because the companies listed on the stock market often do not exactly mirror that country’s economic mix. The JSE has provided a good example of this phenomenon over the past few decades (Why are local equities surging when the economy is spluttering?).
Beyond revenue lie the various forms of cost that the company incurs to generate sales (i.e. cost of goods sold) and run the business (i.e. operating expenses). The relationship between these costs and revenue defines the operating profitability of the company. The US corporate sector’s revenue received a huge boost from pandemic-related government stimulus. Certain industries actually thrived under lockdown, since they provided the tools for remote working or digital goods to bored consumers stuck at home. Most of this additional revenue came without any incremental cost, boosting margins and driving earnings. Governmental furlough programmes spared companies the costs of making workers redundant.
This phenomenon can be seen in the chart below. It shows that net profit margins in both US and other DM large caps hit all-time highs over the past year. US large caps are represented by the S&P 500 index that is made up of the largest and therefore most dominant, well-managed 500 companies listed in the US. Given that the US now represents almost 70% of the DM’s MSCI World Index, we think it is important to split it out from the rest of the DM (which is represented here by the MSCI World ex-US Index).
As the chart demonstrates, net margins in both the S&P500 and DM (excluding US) have trended upwards since the 1990s, as a number of structural phenomena have played out.
China joined the World Trade Organisation (WTO) in 2001, giving manufacturers in developed markets access to a pool of cheap, organised labour in the emerging world. Offshoring has reduced the demand for blue collar labour in developed markets.
Technology has not only reduced the cost of producing physical goods but has created entirely new categories of consumer products, both physical and digital, and new forms of consumption. Many of these new categories have huge economies of scale, creating category behemoths like the US “FANG” platform companies, similar versions in China (including Tencent) and massive semiconductor companies in Asia. As these companies outgrew their old-economy predecessors, their index weight increased accordingly, raising average profitability for their markets as a whole.
3. Capital intensity
The wall of venture capital and private equity seeking out hyper-scaleable technology businesses has tilted the corporate landscape in favour of capital-light businesses and service-based economies. This shift has reduced the average capital expenditure and therefore depreciation charges per unit of revenue across the market.
4.Tax and the cost of capital
Companies can manage many aspects of their cost structure, but not the prevailing cost of money nor the rate at which governments tax their profits. Both have moved in companies’ favour in recent decades. Central bank policy rates have fallen to the lowest levels seen in many decades (ironically, to stimulate inflation), while governments have reduced tax rates to attract corporates, thereby creating employment and economic growth.
Record US margins not restricted to Technology sector
Despite the popular focus on the technology sector it is interesting to note that many sectors of the US market are achieving historically high margins. The chart below shows the past decade’s net profit margin range for both the S&P500 Index, as well as its 11 sectors (weighting in brackets), together with the median margin and the consensus one-year forward margin forecast (“FY1 Forecast”). As you can see, for more than half the sectors, the margin is currently forecast to match or exceed the highest level seen in the past decade.
Margin sustainability key to earnings outlook
History shows us that, regardless of region or sector, margins can rise above or fall below their trend line for a period of time but will then revert to trend. The length of these periods of diversion is unpredictable but the reversion is reliable. To understand the sustainability of margins from here, we need to characterize the current upcycle and identify the headwinds it will face.
The current margin upcycle has been driven by unsustainable revenue growth and pricing power
As shown earlier, corporate revenues are synonymous with nominal GDP and both look set for a softer path after two strong years driven largely by the pandemic-related government stimulus. Both real GDP and inflation are forecast to revert to their pre-pandemic trend over the next two years.
The fixed nature of some corporate costs means that margins tend to increase when revenues increase, and revenue growth has been unprecedented since Covid-19. Companies have also reported unprecedented pricing power over the past two years amid supply-side disruption. This margin upcycle has therefore been super-charged by the combination of government stimulus and the disruption of supply chains by forced lockdowns. This happy state of affairs is already in the rear-view mirror.
If indeed the current level of margins are to some degree the product of Covid-19’s unique ‘moment’ they may have some way to fall, and the clouds are gathering. Recession risks are increasing as liquidity tightens and household confidence collapses. Intuitively, pricing power depends on a robust consumer, which is corroborated by the historic correlation between net margins and consumer confidence in the chart below. The recent collapse in consumer confidence must therefore cast a long shadow over prospects of corporate profitability.
Inventories have been building up
Inventories are another important area to consider, as they were recently ramped up in many sectors to smooth supply chain problems. However, the risks are becoming apparent that goods companies may have overstocked while consumers have redirected their spending from goods to services (i.e. from ordering stuff on Amazon during lockdown to eating out and going on holiday). Inventory build is never good news for corporate earnings. It heralds a period of discounted pricing to clear the build-up, which hits both revenue and margins.
Pandemic-related disruption to global supply chains has caused multinational companies to rethink their offshoring and global procurement strategies. The last twenty years of globalization were a “Goldilocks” period for Western economies: their manufacturers accessed cheap labour in emerging economies, keeping a lid on consumer prices, while China recycled its US dollars into the treasury market, lowering the cost of capital in the US. Covid-19 has revealed the fragility of finely-tuned global supply chains. Bringing manufacturing and procurement back onshore mitigates risk but must also give up some of that disinflationary benefit. DM manufacturers are openly discussing bringing some production back home (aka ‘deglobalization’). Even if this takes time, the end result will be higher overall costs, another drag on current record margin levels.
Commodity prices reflecting geopolitical risk premia
Russia’s invasion of Ukraine is a reminder that Europe’s post-war peace is no longer a given. Meanwhile US-China tensions are rising as China reasserts its historic claim to Pacific hegemony. The likely net effect is a structural increase in implied volatility and rising risk premia in commodity markets, increasing the cost of raw materials for manufacturers which they cannot pass onto a beleaguered consumer.
Wages are the biggest component of the corporate cost structure and we see structural upward pressure to come, adding to the headwinds for margins described above:
- The US labour force contracted during Covid-19 and has not recovered. Companies are having to pay up, either to entice people to come back to work or move jobs.
- Rebalancing manufacturing from offshore to onshore increases labour cost for the manufacturer while increasing overall demand for the country’s working-age pool.
- China has relatively poor demographics. The country’s working-age population started contracting in 2019, according to the World Bank (source link), compromising an important source of global disinflation over the last twenty years.
Tax and depreciation gains are done, and the cost of capital is rising
Lastly, while continued technological development appears a near-certainty looking forward, changes in the relatively low levels of capital expenditure (and hence depreciation), as well as corporate tax rates, are potential longer-term headwinds for margins. In the shorter term, it is clear that currently rising interest rates are having an impact on the debt servicing costs of companies and are providing another headwind for companies’ net profit margins.
What is the market pricing in?
Fans of the Efficient Market Hypothesis regard the market as an all-seeing eye but our analysis is that stocks are not yet priced for record margins to revert to trend.
While the factors listed above have given us various drivers of margins to monitor, especially as companies report quarterly results, it is difficult to get high conviction on the level of margin decline for overall markets. The various moving parts will shift over the coming quarters for each company, which will feed into sector and index level margins. Given that most equity markets have seen substantial price declines in the first half of 2022, it is clear to us that markets are already pricing some contraction in earnings and thus margins. To judge whether the market has sufficiently taken account of the coming downcycle in margins, we have compared the market-implied forward margin to the 10-year range (refer to the Appendix for details of our calculation methodology). We have assessed the margins effectively currently being bought (or ‘paid for’) by using average valuations from the past decade and compared them to the margin range actually achieved over the last decade.
The results for the major DM indices are summarized in the chart below (see Appendix for the US sector results). For US large caps, our methodology suggests that the market is assuming no retreat in margins from current record levels. Outside the US, some decline is being priced in, but in both cases the market-implied margins remain materially above the 10-year median.
Has the market priced in enough of the downside margin risks?
Our conclusion is that excessive pandemic-related monetary and fiscal stimulus boosted the profit margins of developed market equities to record levels.
While it is tempting to believe that the sell-off so far this year has made equities attractive, we are not convinced that the potential downside risk to margins (and therefore earnings) has been sufficiently discounted. This is one piece of the puzzle for our persistent caution on equities over the tactical (12-month) time horizon.
While it is difficult to forecast the extent and pace of the margin downcycle, it is important to remember that margins have been reliably cyclical in the past. If this relationship holds they must be vulnerable now as the threat of recession looms amid rampant inflation and rising interest rates. Equity valuations which imply little or no reversion in margins must therefore be at risk.
As you can see in the chart below, ACWI’s annual revenue growth is closely tied to World Nominal GDP growth, which makes intuitive sense for the overall equity market.
One of the major drivers of the strong recent sales growth globally, but especially in the US, was the excess monetary and fiscal stimulus provided from Q2 2020 when the pandemic lockdowns spread globally. The chart below shows that, since the pandemic-related stimulus began, US large companies’ sales growth, as well as Nominal GDP growth, have been the highest this century. This is also one of the main reasons for the very strong housing and labour markets in the US.
Methodology used to determine market-implied forward margins
We use the following methodology and assumptions in determining the market-implied forward margins per index/sector:
- Use the consensus one-year forecast revenue.
- Use the median 10-year forward price-to-earnings (“PE”) multiple (we use the shorter 10-year period to capture both the very low interest rate environment and the upward trending margins).
- Back-out the implied forward margin level using the above two inputs and the current price (which includes the material drawdowns this year).
- Compare that market-implied forward margin with the 10-year median and high margin levels to get a sense of what the market may have already priced in.
From a US sector perspective, the chart below shows that more than half the sectors, including the largest three by weight, have market-implied forward margins still above their 10-year highs! Most of the sectors also have market-implied margins materially above their 10-year medians.