- Markets may be focused on China’s devaluation, but I’m still paying attention to US profits.
- A commodity-driven earnings recession has plagued capital-heavy sectors like energy and materials.
- I think missing out on a renewed market advance could be the biggest risk for equity investors.
While the markets have been fixated recently on China’s currency moves, I have other things on my mind. I’ve been thinking that it has now been six years since the end of the last recession — making this expansion one year older than the average life span of business cycles after World War II. And for most of these six years, the United States has been on an impressive ride, both for company profits and the equity markets.
US GDP growth has belied such optimism, however, hovering at a slower annual pace — around 2%, based on the latest revisions — than we experienced in other cycles. Confirming this sluggish growth, the anemic sales reported by companies in the S&P 500 Index over this period have also been below historical norms.
Yet at the same time, corporate profits have been anything but anemic. Gross profits in the S&P 500 remain strong, net profits have been exceptionally robust and the broad measure of overall profits as a percentage of US GDP is at or close to the highest ever witnessed. No wonder the stock market has appeared to move upward with blinders on, ignoring the news reports of substandard economic growth.
Profit expansion
Where has this rise in profits come from? I can think of several sources.
Labor costs are typically the most important subtraction from revenues, but during this cycle, annual increases in wages and benefits have been running below the economy’s weak rates of growth. US workers have so far been unable to argue for higher pay and a bigger share of the economy’s expansion — a lingering residual of high unemployment in the 2008–2009 recession.
Labor globalization has also been a factor. Access to cheaper workforces in Asia and South America has helped the production chain achieve huge cost savings, especially for multinational companies.
Technology has been another source of US profit expansion, reflected in asset turnover. Of the world’s major economies, the United States has the highest return on book equity (ROE). Part of the ROE equation is how efficiently companies use — or turn — their assets, which has improved greatly over the past 20 years. The highly profitable technology sector has risen as a percent of the S&P 500’s market weight, and the use of technology has helped other sectors generate rapid growth in earnings and cash flows.
Other advantages for the US include lower energy costs, which have been a tremendous benefit for manufacturing, chemicals and plastics. Low interest rates, modest additions to debt burdens and the shrinking of common share counts through repurchases have also enhanced margin improvements. Add all these factors together, and profits and free cash flows have been the story of this cycle.
Commodity recession
Lately the materials sector has been hit by trying to export products while contending with a strong US dollar and slow world growth. The energy sector, which accounts for about 9% of the S&P 500, has been reporting large decreases in sales and profits. These big capital spenders, who had enjoyed sizable sales increases from investments in pipelines and drilling, are now experiencing revenue and profit declines.
I call this period a commodity-driven earnings recession. We have seen three past instances when the prices of oil and other commodities have fallen without a more widespread US recession. Looking back at each case, the bad news in the earnings reports lasted about two quarters, followed by a general pickup in growth. This then led to higher profits — not from margins, but from old-fashioned gains in sales against a base of mostly fixed costs that rose more slowly.
As I see it, we are now at that inflection point. Either global growth picks up soon — getting a push from lower energy input costs and the better buying power granted to US consumers by the rising dollar — or world growth flattens out for other reasons — possibly China — and profits begin to fall.
At an earnings multiple of 18, the market is not priced for such a collapse in profits. Next year, when we look in the rearview mirror, will we see that as a bubble? I don’t think so. I suspect that lower oil, gas, copper and iron prices could spur spending, bringing better growth in profits later this year. The market price today may turn out to be prescient.
Currency wars
Just a few days ago, China added currency depreciation to the list of global market concerns. Some have argued that this could be negative, leading to competitive devaluations in other national currencies.
While that may happen, it is important to remember that the renminbi has been appreciating for several years. China’s devaluation was intended to reverse that trend and make its goods more competitive in the global marketplace. That could trigger faster growth in China and the rest of the world, which would be positive — and counter to the fears of China’s economic slowdown that have so roiled the financial markets recently.
How far does China want to see its currency fall against other currencies? We don’t know. So there may be more uncertainty in the global outlook after this week. As I see it, however, a weaker renminbi gives US consumers more buying power, helping to stimulate the world’s biggest source of final demand. Admittedly, some US sectors do get hurt by a stronger dollar. Yet with exports accounting for only 13% of the US economy, foreign exchange fluctuations are not likely to derail the current US expansion. Though currency wars can be destructive, they tend to be only temporary skirmishes. Competitive advantages in unit labor and energy costs, as well as technology’s dominant role in the economy, should continue to tilt the playing field toward the US.
Opportunity risk
I see another hazard in the markets that could be called “opportunity risk.” Pessimism is running high, investors are being cautious and mutual fund cash balances have been climbing. But if history is right about earnings recessions caused by weak oil prices, then profits may be poised to rise once more. Corporate efficiency is strong, without much financial leverage. So any topline revenue improvement would go directly to enhance earnings growth.
The continuing story of slow wage growth and subdued inflation has allowed the US Federal Reserve to wait longer to normalize monetary policy — delaying interest rate increases and supporting the margin story that has been in place for this whole cycle.
In addition to these fundamentals, we are in the third year of the US presidential election cycle. Based on historical patterns, the market tends to deliver higher-than-normal returns in that year. For seasonal reasons, the market generally moves up the most in the third or fourth quarter. And when — perhaps later this year — the Fed does begin the hiking cycle, then we can expect the market to make decent gains one year after the first rate increase, if past experience is any guide.
So yes, one could argue that it’s important to be cautious and hold on to existing gains. But it’s also possible that the biggest risk may be the opportunity risk of missing out on what could develop as another leg up in one of the most significant, fundamentally based market advances of the past 70 years.
No forecasts can be guaranteed.
The views expressed are those of James Swanson and are subject to change at any time. These views are for informational purposes only and should not be relied upon as a recommendation or solicitation or as investment advice from the Advisor.
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