How high can profits go?

29 November 2018

By Colin McQueen, head of Global Value team

 

Strong earnings growth has been a powerful tailwind for equity returns over the last two years, with earnings rising by 40%. Consensus estimates expect these gains to continue, with another 17% rise in earnings forecast over the next 12 months.
 

But how reasonable is it to expect strong growth to continue?

 

Rather than simply trusting to our crystal ball to predict the future of the economy, we look more directly at corporate profitability and consider two measures of aggregate profitability to better gauge where corporate returns are compared to history, and how reasonable it is to expect future gains.

Looking first at operating margins, a significant expansion in profitability is clear, with margins having reached new peaks for this cycle. Whilst still below the peaks of the cycle seen in 2006/7, these levels are now considerably above historic medians, and by historic standards are much closer to peak than trough levels.

Slide1.JPG
Slide2.JPG

A similar pattern emerges with aggregate return on equity for companies in the MSCI World index. After seeing dramatic falls during the financial crisis, companies experienced a relatively tepid recovery during the first half of this decade.  However, over the last two years returns have improved dramatically leaving corporate profitability now above historic levels. This does not mean that it can’t move higher but it has already reached the peak of the 99-2000 bull market. Returns did go higher during the US housing bubble but ultimately proved to be unsustainable.

It is not simply the economy that has driven returns over this period as companies have also benefited from very low interest rates and from cuts in corporate tax. Both of these drivers are likely to have run their course, leaving only the economy to carry things forward.

Economic theory suggests that high returns on capital should attract new investment and increased competition to an industry, which makes high returns hard to sustain for long periods.  It is quite likely that the benefits of tax cuts represent a pull-forward of future profits rather than a permanent gain.
 

Would a stronger economy automatically translate into further profit gains?

 

Over time corporate profits have tended to grow faster than GDP (with the share of wages falling), but this trend tends to reverse during recessions and periods of very tight labour markets.

On inspection of the total profits as a share of the US economy (“the profit share”), it has risen over time and is again high by historic standards. At some stage during an economic recovery, labour markets tighten and the wage share expands. With global labour markets beginning to tighten, the potential for profits to continue to expand ahead of GDP becomes harder.

Slide3.JPG

Strong profit growth has been a tremendous tailwind for markets over the last two years. Cutting the data a number of different ways suggests that corporate profitability has now moved above historic levels.

This does not mean that profits can’t continue to grow near term, but the potential for a continuation of recent gains seems more limited and the risks of disappointment have risen. This suggests investors should temper total return expectations and the sustainability of future earnings takes on an increasing importance.

Please agree to proceed. By doing so you agree that you have read and understood the foregoing disclaimer and confirm that you are a professional investor.

Please navigate to a service or product page and add the document to your brochure to continue.

Back
Name your brochure
Your details
Thank you!

Your brochure is on its way.

Brochure Confirmation - your brochure is on its way.

We hope you find this useful.

The value of investments and any income from them can fall and you may get back less than you invested.