Earnings are a key driver of equity returns. That’s why we care about profit margins, which we expect to fall this year.
But not all profit margin data are created equal, we find. We base our analysis on the profit margins in the national accounts data (NIPA) from the U.S. Bureau of Economic Analysis. We prefer to focus on this profit margin data for several reasons, as we write in our Macro and market perspectives Profit margins under pressure.
1. Profit margins derived from NIPA data tend to lead the S&P 500-based profit margins. Over the past the 30 years, turning points in NIPA margins have preceded those for the S&P by an average of three quarters. See the chart below. NIPA data feature a larger and more comprehensive sample of companies –including private, unlisted companies that play a greater role in the economy.
2. NIPA data have a longer history than S&P 500 data.
3. NIPA data separate domestic and repatriated foreign profits, while the S&P 500 data only separate revenues. Given the rising role of China in global growth, S&P 500 companies are increasingly sensitive to foreign earnings.
4. NIPA’s accounting methods ensure uniform depreciation schedules are being applied, while excluding one-off debt write-downs and land depreciation.
5. NIPA data are based on a broader set of data sources than just regulatory filings. NIPA data can be revised regularly and materially. But we find that unrevised NIPA profit margins still lead S&P 500 margins similar to the chart above, so we don’t view this as a major drawback.
The outlook for NIPA profit margins
Where are these NIPA profit margins headed as we enter the late phase of the U.S. business cycle? The chart below shows NIPA profit margins “detrended” – stripped from the influence of long-term secular shifts such as globalization and increased industry concentration. We do this so we can see the cyclical swings in profit margins more clearly. Next to this on the chart is a forecast (see the “Estimated and expected margin” line) of this detrended margin over time. This forecast is made using a statistical model that includes measures of economic overheating (the output gap), measures of real unit labor cost growth, measures of output price inflation and measures of output growth.
Historically, profit margins have dropped from their peaks in the late phase of the economic cycle. This may sound counter-intuitive: textbook economics would suggest that companies have more pricing power when the economy operates at or above full capacity and inflation picks up. But under imperfect competition (the norm in most markets), companies tend to give up pricing power to gain or defend market share. The willingness to give up pricing power will likely reflect adjustment costs in both capital and labor.
Theory shows that the more monopolistic markets become, the more companies tend to eat into margins to defend market share when revenue growth starts to slow. The more margins fall, the lower inflationary pressures are – possibly further extending the economic expansion.
The stage of the cycle also matters: for most of the business cycle, margins move with the output gap. Profit margins expand in the mid-cycle phase as the output gap converges to zero and full capacity is reached. But in the late-cycle stage, margins move in the opposite direction of the output gap. The more the economy overheats, the lower the margins. During the late cycle, costs tend to rise most quickly just as revenue growth heads lower, overwhelming the increased output price inflation.
Our estimates show that margins are likely to decline this year, falling further below their secular uptrend. Much of this is due to rising overall capacity utilization – the stage of the business cycle – which we expect to rise further during 2019. Together with a rise in unit labor costs, this will outweigh the projected increase in the GDP deflator, a measure of price inflation. Read more macro insights in our latest Macro and market perspectives.
Elga Bartsch, Head of Economic and Markets Research for the BlackRock Investment Institute, is a regular contributor to The Blog.
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