The coming flattening in U.S. profit margins
This post is a guest contribution by Richard Berner & the US Economics team of Morgan Stanley.
Earnings deceleration despite economic acceleration. We think earnings growth will slow significantly despite a moderate US economic acceleration in 2011 – to 4% real growth from 3% in 2010 (on a 4Q/4Q basis; on a year-over-year basis we think real growth will accelerate to 3.6% from 2.9%). The culprit is a coming flattening in profit margins. Slower output growth abroad, fading operating leverage, and an end to the decline in interest expense will likely all contribute to flatter margins.
We think the slowing in earnings growth is coming by any metric: Our colleague Adam Parker expects S&P EPS growth to slow dramatically from 47% in 2010 to 10% in 2011 and 6% in 2012. Measured by so-called after-tax economic profits, and on a comparable year-over-year basis, the corporate tax cuts enacted late last year and effective in 2011 mean that the deceleration initially will likely be less pronounced – from 24% in 2010 to 17% this year. Over a longer horizon, the deceleration is clearer: Strong earnings growth in 2011 will come at the expense of 2012, when we expect an outright decline in after-tax economic profits.
Four reasons margins soared. To understand why margins will flatten, it’s important to analyze why they soared since their trough in 2008. The consensus explanation is that aggressive cost control, especially control of labor costs, boosted productivity and profits. We agree that hiring discipline helped, but labor cost control is only one of four key factors that boosted margins.
First, strong growth abroad, especially in the booming EM economies, has lifted results of US affiliates abroad. Global growth moved up to 5% last year, rebounding sharply from the 2.8%, crisis-induced ‘slump’ in 2009, and the 7.5% pace in EM economies nearly matched the blistering 2003-08 average. As a result, earnings from abroad rose by an estimated 17% last year, and US companies’ profits in relation to US GDP got an extra boost.
In addition, strong capital discipline enabled companies to exploit their operating leverage, increase operating rates and boost returns on capital. Capex outlays fell below depreciation for the first time in 50 years last year, hinting that the net capital stock declined for a second year in a row; in the prior 60 years, the capital stock had never declined. Similarly, industrial capacity shrank by 1.5% over the past two-and-a-half years – the biggest decline in six decades. As a result of that shrinkage, a moderate economic recovery promoted a 780bp surge in factory operating rates from their trough in June 2009 – the fastest jump in industrial operating rates since 1984 – and in our view, more increases are on the way.
Next, financial discipline promoted strong control over balance sheets, which kept a taut rein on interest expense. Net interest expense for non-financial corporations in relation to sales (GDP) has plumbed record lows in the past year, reflecting the combination of a sharp contraction in short-term credit demands and low interest rates. Finally, hiring discipline also helped. Layoffs trimmed compensation, especially by reducing the costs of healthcare benefits that are fixed per worker but are rising much faster than inflation.
Four sources of flatter margins in 2011. First, growth in overseas output – which is what matters for profits – is likely to slow somewhat. We expect global growth to slow to 4% in 2011 from 5% last year, and the slowing will be most apparent in Asia and Latin America. Tighter monetary policies and stronger currencies in the fast-growing EM economies likely will slow growth to 7.9% in Asia ex Japan from 9.2%, and to 4.2% in Latin America from 6.1% last year. A weaker dollar against AXJ and LatAm currencies will be a modest offset, translating overseas earnings from those regions into more dollars. In Europe, fiscal restraint will promote slightly slower growth in the UK and will have a more pronounced effect on the peripheral economies of the euro area. In addition, a stronger greenback against the euro will weigh on earnings.
Second, and more subtle, operating leverage will fade as fixed costs like depreciation will start to catch up to sales. That’s likely as capital spending picks up and depreciation expense rises. We also expect hiring to accelerate, which will boost both the variable and ‘fixed’ costs of compensation, including healthcare. Third, declines in interest expense for non-financial corporations will end, first, with a pick-up in credit demand, and more when rates begin to rise later this year.
Commodity squeeze? Investors are worried that rising commodity prices will foster margin compression. The thesis: Commodity quotes – for energy, foods and basic materials – are soaring, but companies cannot pass through these rising costs. That’s because pricing power is lacking in a world swimming in excess capacity or slack. And it’s not just commodities; import prices are beginning to rise, reflecting rising inflation in Asia and a weaker dollar versus Asian currencies. Prices for imported apparel and footwear accelerated to a 2.6% rate in the year ended December.
For some industries and companies, that’s a legitimate concern. To quote US equity strategist Adam Parker, “Rising input costs in mid-tier department stores, select restaurants, apparel, food retailing and transportation companies have now begun to surface as a potential impediment to margin expansion in 2011.” For others that have pricing power, it may be less of a concern. In this environment, Adam believes that pricing will be a key issue and investment theme for 2011.
Differentiating according to pricing power. We couldn’t agree more about the importance of pricing power. In the aggregate, therefore, we think that concerns about the commodity squeeze on margins are overblown for two reasons. First, the cost of materials is actually a relatively small share – about 14% – of gross industry output, so a 10% jump in materials costs will increase costs and compress margins by one-seventh of that increase, on average. Second, and more important, the capital discipline and rising operating rates that boosted margins early in the recovery will now promote pricing power for goods sold, help top-line growth, and sustain margins for some sectors.
More broadly, we believe that inflation is bottoming and will gradually move higher. A tug of war is underway: Significant slack in markets for goods and services, housing and labor will depress inflation. But stable-to-higher inflation expectations will push it higher. While operating rates are low and the jobless rate is high, changes in those gaps – so-called ‘speed effects’ – are promoting an inflation inflection point. Whether manifest in sectoral pricing strength or in pricing aggregates, the debate around inflation and pricing power will be critical in 2011.
Source: Richard Berner & the US Economics team of Morgan Stanley, January 18, 2011.
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