WARREN BUHAI: While companies are making record margins equities are in for tough times

The first half of 2022 was traumatic for investors. Just as the global economy was rebounding from Covid-19 the war in Ukraine sowed chaos through financial and commodity markets and worsened existing inflationary pressures.

Central banks are under pressure to act, despite being ill-equipped to cool supply-side inflation. Volatility has increased across most asset classes and can be expected to remain elevated if inflation persists. We have seen some of the worst first-half returns for equities and bonds in many decades, but there may be more to come.

However, remember that successful investors stick to fundamentals and invest when others are fearful, and there is no greater fundamental driver of equity markets than earnings. The value of any individual equity can be understood as a multiple of its future earnings: the stream of earnings is what you “get”, the multiple is what you pay for it. That multiple will expand and contract over time, reflecting changes in investors’ mood, but earnings are a real-world phenomenon that we can interrogate.

Net profit margins at record levels

The US corporate sector’s revenue received a huge boost from pandemic-related government stimulus. It lifted margins and drove earnings up. The chart shows that net profit margins in both US and other developed market large caps hit record highs over the past year.

As the chart demonstrates, net margins in both the S&P 500 and developed markets (excluding the US) have trended upwards since the 1990s. We believe this has been driven by structural phenomena: China’s growth as a source of low-cost manufacturing, the explosion of technology, the shift towards asset-light business models, and falling interest rates and tax rates.

The recent jump in margins to record highs was driven from the top line by a combination of government stimulus and pricing power amid disrupted supply chains. Unfortunately, both of these catalysts have run their course, and a recession is looming as liquidity tightens and household confidence collapses. All of this casts a long shadow over the outlook for margins at a time when other factors are threatening to both impede revenue and increase companies’ costs.

These other factors are:

• Inventories have been building up. We believe goods companies may have overstocked while consumers shifted their spending from goods to services (from ordering products on Amazon during lockdown to eating out and going on holiday). Inventory build threatens a period of discounted pricing to clear the build-up, which hits both revenue and margins.
• Deglobalisation. Pandemic-related disruption to global supply chains has caused multinational companies to rethink their offshoring and global procurement strategies, threatening an end to two decades of benign disinflation.  
• Commodity prices rise to reflect geopolitical risk premia. Russia’s invasion of Ukraine is a reminder that Europe’s post-war peace is no longer a given, increasing uncertainty over the future supply of raw materials. The result is higher input prices for manufacturers, which they may struggle to pass on to an embattled consumer.
• Wage inflation. We see three structural trends applying upward pressure to developed market companies’ cost of labour: the shrinkage of the US labour force, the contraction in China’s working age population and deglobalisation.
• Tax and depreciation gains are done, and the cost of capital is rising. An increase in the relatively low levels of capital expenditure (and hence depreciation), as well as corporate tax rates, are potential longer-term headwinds for margins. In the shorter term, companies’ debt servicing costs are rising.

What is the market pricing in?

To estimate whether this year’s pullback in the equity market has priced in a downcycle in margins we have inferred forward earnings from current share prices and long-term average price/earnings multiples. We compared those inferred earnings with forecast revenues to derive an implied margin, which we compare with the range of margins actually achieved over the past 10 years.

This methodology suggests the US equity market is assuming no retreat in margins from current record levels. Outside the US some decline is being priced in, but in both cases the market-implied margins remain materially above the 10-year median, and at record highs in some markets.

Despite the threat of recession amid rampant inflation and rising interest rates, equity valuations seem to be reflecting a conviction that margins will remain at record levels. As a result, we believe there is a risk of further downside for equities.

• Buhai is senior portfolio manager at Stanlib Multi-Strategy.