Today's Fat Profit Margins Aren't About American Workers Getting Squeezed

Fat corporate profit margins have been a key driver of the surging stock market.  Indeed, this has been the foundation of recent earnings growth.

But is this sustainable?

“One of the most common bearish arguments that we hear from clients is that margins are mean-reverting,” writes Dan Suzuki, equity strategist for Bank of America Merrill Lynch. “With net margins near record levels, a reversion to the mean would result in a 15-20% hit to earnings.”

This is the position shared by the likes of John Hussman, GMO’s Jeremy Grantham, and SocGen’s Albert Edwards.

Some have attributed recent profit margin gains to companies squeezing more out of their workers.  This would explain why corporate profits have surged to record highs even as wages have stagnated and unemployment rates remain stubbornly high.

Low wage-driven margin gains are unsustainable, warns David Rosenberg.

However, the bears appear to be focusing to much on what amounts to be a small component of margin gains.

“There are several reasons why margins should remain structurally higher than the
historical average,” writes Suzuki. “Importantly, roughly two-thirds of the improvement in net margins can be attributed to changes below the operating line, specifically interest expense and taxes.”

Here’s Suzuki’s breakdown of how margins got to be so fat.

profit margins

And Suzuki thinks low interest expense and taxes are sustainable:

The S&P 500’s effective tax rate has fallen as an increasing share of profits is being generated from overseas where tax rates are lower. We do not expect any meaningful decline in the share of foreign profits, and if we eventually see US corporate tax reform, most of the proposals actually call for corporate tax rates to be lowered, not raised. Meanwhile, lower leverage levels and interest rates have reduced the interest expense burden of companies, and although we could see interest rates rise from current depressed levels, we would still expect them to remain well below history. We also do not see any rush for corporations to meaningfully re-lever their balance sheets for the foreseeable future. Every 10bp of margin expansion translates into roughly 1ppt faster EPS growth relative to sales growth.

Suzuki believes it’s a mistake to think that margins will revert to a long-term mean just for the sake of reverting to a mean.

Rather, he argues that high margins reflect a long-term structural change, not a short-term cyclical one.  This has long been the position of veteran market strategists David Bianco of Deutsche Bank and Brian Belski of BMO Capital.

So, while it may be the case that low wages are unsustainable, the profit margin story is being driven by much larger long-term forces.

profit margins

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