Answers to our clients’ questions about market action and the market environment in a few paragraphs every two weeks.
No. While US companies have some defensible profitability advantages, today’s elevated margin levels may be poised for a reversal of fortune. Six key factors have supported high US profit margins: increased globalization, cost-reducing technological advances, broad declines in labor’s negotiating power, less restrictive anti-trust enforcement, lower corporate taxes, and cheaper credit costs. Some of these key forces are starting to fade, while others still have some momentum behind them. On balance, the evidence suggests we are at or very near peak margins and should be prepared for margin compression over time.
According to analysis by investment research firm Empirical Research Partners, manufacturers in the S&P 500 Index are responsible for half the index’s earnings and generate profit margins 9 percentage points higher than the rest of the market. Their research revealed that manufacturers’ margin expansion was driven by three roughly equivalent factors: (1) wage savings from offshoring and robotics, (2) global tax arbitrage, and (3) falling interest rates.
The trade war directly threatens the part of the market that has generated most of the margin expansion—the tech sector and other global manufacturers. Even without added tariffs and supply chain restructuring, future wage savings from offshoring may be limited. Chinese hourly manufacturing compensation costs have increased from 2 cents to 14 cents on-the-dollar relative to US costs since China joined the WTO in 2001, with all-in manufacturing costs coming close to parity with the United States. Asian competitors (e.g., Vietnam, Bangladesh) offer lower production costs, but there are limits on their ability to handle the same types of manufacturing done in China without meaningful investment and time to improve.
Robotics appears to have plenty of room for continued penetration into manufacturing. The global operational stock of industrial robots has grown at a 10% annual growth rate since 2009. US robotics use lags Asian countries, leaving more room for further robot adoption to cut costs. However, even as automation reduces costs, improving margins of individual companies, such productivity enhancements could eventually reduce overall employee compensation enough to limit US consumption and ultimately the aggregate profit margins of its companies.
Globalization and reduced employee bargaining power have contained wage growth. A sharp decline in organized labor and increased concentration in US industries have limited workers’ bargaining power, while concentration has also supported companies’ pricing power. According to the US Department of Labor, the percentage of US employees in a labor union has halved since the 1980s to just 10.5% in 2018. At the same time, increased mergers & acquisitions activity, amid decreased antitrust enforcement, has boosted industry concentration in the United States. Researchers Gustavo Grullon, Yelena Larkin, and Roni Michaely found that a commonly used measure of index concentration, the Herfindahl-Hirschman Index, has increased more than 70% since 1997, reflecting significantly higher market concentration among US publicly traded firms in the Center for Research in Security Prices database.
Finally, while it is possible for tax rates and interest expenses to decline further, this is not a reasonable base-case assumption, given the considerable decline in tax rates, the increase in government debt, and the very low level of interest rates. The effective tax rate of US publicly listed companies has fallen from about 45% in the 1970s to about 20% today. These forces may not reverse course in the near term, but they are unlikely to provide a means for further margin expansion.
Profit margins have remained elevated for an unusually long period as numerous forces converged to expand margins to new peaks. However, the tide appears to be turning on some of these secular trends. Even as companies see diminishing marginal gains from offshoring, falling rates, and lower taxes, negative sentiment toward globalization and large companies in general has been mounting in the current populist environment. Profit margins are likely to compress over time, as globalization trends become less favorable and as large companies come under pressure from politicians seeking improved income equality and increased market competition.
A decline in margins will take away one of the pillars that has supported an unusually high valuation premium for US equities relative to global ex US equities, one of several catalysts that could trigger a convergence back toward average historical levels. Of course, timing of any such reckoning is unpredictable and could wait until the next recession, particularly as US equities tend to be defensive in times of stress. Given the stage of the economic cycle, we continue to recommend modest underweights to US equities relative to global ex US developed and emerging markets equities. We would look to increase underweights in a recession-related bear market.