Corporate profit margins for S&P 500 companies are at all-time highs.
And the bulls insist that margins are at least sustainable over the near-term. They remind us that labour market slack will keep wage cost growth limited, deleveraging will limit the impact of higher interest rates, and increasing overseas exposure will keep overall taxes and operating costs low.
Deutsche Bank’s David Bianco is one of these bulls who sees net profit margins going even higher in 2014.
At a breakfast on Thursday, Bianco reminded us that pension expenses will be substantially lower.
Remember, during the financial crisis, asset values plunged sending pension funds deep into under-funded status. As a result, corporations had to pour increasing amounts of money into these pensions to help bring them closer to fully funded status. And that was recognised on the income statement as higher pension expenses, which put pressure on profit margins.
But thanks to the help of an unexpectedly powerful recovery in stocks, these funds are nearly back to pre-crisis levels.
“Pension plan funding status at 2013 end vs. 2012 end will affect 2014 EPS,” said Deutsche Bank’s David Bianco in his 2014 outlook note. “Our 2014E S&P EPS of $US119 includes $US1.50 of lower pension costs, but it could easily be anywhere from a $US1.00 to $US2.00.”
That is a massive relief for corporate costs.
But doesn’t this just mean that the next stock market pullback will slam margins again?
Not likely. Keep in mind that most companies have shifted from offering defined benefit plans (i.e. pension plans) to offering defined contribution plans (e.g. 401k plans), which puts all of the investment risks squarely on the employee. Those on pension plans will soon retire, which means pension fund managers will be scaling back risk (i.e. selling stocks and moving into bonds).
Here’s Bianco with more commentary:
The last decade has been a long and bumpy road for managers of and investors in companies that sponsor large defined benefit pension plans. We think the number one priority of managers and desire of most investors we talk to is to put everything related to DB pensions behind them in the past. We think treating pensions as a legacy issue will be the general strategy of most sponsor company managers. Isolating pension risk and eliminating or at least minimising the effects to earnings and the balance sheet will take top priority. Given the strength in corporate profits, free cash flow, balance sheets and generally diminished fears of economic shocks, we think companies will take proactive steps to further improve their pension funding in 2014 and 2015. We think companies will voluntarily make deficit reduction contributions and further explore and utilise lump-sum settlements with retiring employees.
The outflows fly in the face of the popular “great rotation” theme, the shift from bonds to stocks that some argue is a big bullish force for the stock market.
Bianco isn’t convinced these pension fund outflows won’t be large enough to put the stock market at risk.
..a return to near full funding likely accelerates S&P pension liability immunization: selling stocks to buy bonds. Many companies might simultaneously issue more debt to repurchase shares. We expect nearly $US150bn of annual S&P pension asset allocation equity outflows in 2014 and 2015 as the average equity allocation of S&P 500 plans drops from 45% to roughly 30%. We do not see this as a threat to healthy S&P 500 returns through 2015, but it should help slow the ascent in long-term interest rates and keep corporate credit spreads tight.
A few years ago, everything about pension funds spelled trouble. It’s nice to hear things have turned around.
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