The coming squeeze on US profits
Progress on US-China trade talks has seen investors’ concerns about a trade war fade, and be replaced instead by worries about economic growth and politic risks. The real concern for equity investors, ultimately, is how slower growth will be reflected in company profits.
In 2018 markets were driven by stronger corporate earnings, but share prices still slipped back as interest rate rises caused investors to reappraise valuations. This year looks like being the reverse, as we forecast earnings to slow whilst the central bank stands back.
Lower inflation and rising wages put pressure on profits
One of the key changes in our recent forecasts for slower growth is an update on the inflation outlook. Inflation looks set to be weaker than previously expected and this has fed into a more accommodative monetary policy stance from central banks.
Whilst this can be seen as positive for stock markets (lower interest rates make cash savings relatively less attractive), lower inflation can increase pressure on profit margins. Companies are facing rising wage costs. When higher inflation is accepted, the increased costs of labour can be more easily passed on through higher end prices. When inflation is constrained and producers are unable to pass the additional costs on, then profit margins take the strain.
One of the key features of the most recent economic expansion has been the elevated level of profit margins enjoyed by companies. For the US market, this is indicated by the high profit share as a percentage of GDP, shown in the chart below.
US profits as a percentage of GDP
Source: Thomson Reuters, Schroders, 21 March 2019.
Past performance is not a guide to future performance
The flip side of this of course has been weak wage growth. In many countries, this has translated into dissatisfaction with the economic status quo, stoking the flames of populist politics. Going forward, we think this could change.
US profits set to fall in 2020
We take a top-down approach to forecast the share of profits in GDP via profit margins and capacity utilisation. Capacity utilisation measures the extent to which businesses are using their capacity to produce goods or services. Our forecast for this is driven by GDP growth, while the forecast for profit margins is also affected by growth in labour costs, prices and productivity.
We do not expect a US recession (i.e. two consecutive quarters of negative economic growth) but our forecasting model suggests caution on US earnings would be appropriate. We expect profits to peak in Q3 2019 and to decline in line with a weaker US economy thereafter. Overall, we forecast US profits (excluding financials) to rise by 6% in 2019 but to fall by 4% in 2020.
This is because below-trend economic growth means lower capacity utilisation, putting downward pressure on profits. Moreover, profit margins will be squeezed as labour costs rise, while inflation and productivity decline on the back of weaker growth.
Profits could fall further in alternative scenarios
While the above reflects our base case, we have also modelled a number of alternative scenarios. Unsurprisingly, the share of profits would see a sharper decline should a US recession occur in 2020. In that scenario, profits could fall by 13.5% (see light green line on chart below). When modelling a scenario of a global recession excluding the US, the fall in profits came in at 7.4% in 2020 (dark blue line).
Only two scenarios pointed to profits growth. Either China tries to avert a deeper economic slowdown by stimulating growth and inflation through extra fiscal spending or US growth surprises again through a stronger supply side (purple and red lines).
US economic profits (ex financials) set to peak in Q3 2019
Source: Thomson Datastream, Schroders Economics Group. 27 March 2019.
The above is a forecast based on top-down economic factors. Actual profits, or earnings per share (EPS), for the S&P500 (the large cap US equity index) will be more volatile. This is because of the effects of a company’s borrowings and write-offs. However, we would expect the direction of profits to be similar and so we can make an estimate of market EPS.
We estimate that S&P500 operating earnings will rise by 6.8% in 2019, while reported EPS increases by 7.8%. The decline of the profits share in 2020 would reverse these gains; operating earnings would drop by 3.4% and reported EPS by 6.9%.
Operating earnings are profits earned after subtracting from revenues those expenses that are directly associated with operating the business. Reported earnings include non-recurring items (e.g. the one off cost of closing down a factory).
This analysis of profit margins suggests we will see a squeeze on corporate earnings in 2020. Corporate cash flows will come under pressure and this will provoke a reaction. Typically companies would cut jobs and capital spending. The knock-on impact of this could bring the economic cycle to an end, leading to recession. Our model currently puts a 36% probability on a US recession in the next 12 months – the highest probability since 2007.