Corporate Profit Margins Headwinds vs TailwindsJun 10, 2019

Macro factors have been moving markets and the current trade spat is just the most recent example. As long-term investors we need to also make sure we are focused on the fundamentals. For stocks a key determinant of longer-term performance are earnings and corporate profitability. Margins have had a record run as seen in chart below and certainly equity returns have benefitted, but a decline in margins would of course have more negative implications.

Structural tailwinds to corporate profit margins

There have been various factors that have helped boost margins over past couple of decades:

  • Globalization and the availability of cheap labour promoting corporate offshoring of manufacturing process reducing corporate costs
  • Less unionization reducing bargaining power of workers muting wage costs for corporations
  • Technology advancements allowing more automation of production processes further reducing costs and increasing productivity
  • Generally favorable public policy benefitting corporations creating higher concentration within industries and a “winner takes all” corporate environment *

Although the above has been great for corporations and profitability, the negative side effects are less participation by the worker in profits, the rise in inequality and increased populism. The chart below highlights this effect in the US as the top 1% of the population holds more and more of the total wealth.

Factors influencing margins going forward

Some reversal of the above trends should be expected to the detriment of corporate profitability but other beneficial factors for margins are expected to remain in place.

  • Recent trade tensions and tariffs are a reminder that we may have potentially hit peak globalization and some countries may become more inwardly focused going forward. This could stymie the trend of rising margins and even cause a decline should trade frictions increase costs more dramatically.
  • Politically the US 2020 election will be key to watch as some of the more left-leaning Democrats are looking to introduce policies that will likely hurt corporate profitability as they look to reduce corporate power and bridge the wealth divide.
  • We should see a continued increase in wages given the tightness of the labour market but given decent productivity gains more recently weaker unit labour costs have muted the effect on corporate margins have thus far.
  • Technology has the potential to continue to benefit margins as large-scale adoption of robots and other technological innovations is yet to come.

Investment implications

It is hard to gauge the impact of the more structural headwinds to margins from peak-globalization and potential political shifts, but some companies are seeing margin pressure from higher wages and input costs now. There is some intention by companies to raise prices to maintain profitability, but it remains to be seen how much consumers will bear. 

Trade tensions could boost input costs and hit profitability in more cyclical industries such as autos, industrials, and technology, but even in other industries as well if things continue to escalate. Trade tensions will likely have some damaging effect on macro drivers such as consumer confidence, business sentiment, and financial conditions, which would also indirectly impact future profitability via weaker top line growth.

From a positioning standpoint we have been a little more cautious on our asset allocation with an underweight to equities and a reduced credit risk. Although the risk of a margin collapse is small, some headwinds are evident and although not the sole reason, it does suggests a more cautious approach toward equities.

*for more on this subject I recommend “The Myth of Capitalism, Monopolies and the Death of Competition”, by Jonathan Tepper with Denise Hearn.