Profit margins are near historic highs. Believe it or not, analysts expect margins to expand even further. Here’s a chart from UBS, which we’ve seen before from Morgan Stanley.
Stock market sceptics are concerned that the current rally is largely being driven by high profit margins as well as the expectations for even higher margins.
They worry that a turn in margins could translate to lower profits, which could lead to a sell-off in stocks.
However, the conditions under which margins contract are crucial.
UBS’s Global Macro Team led by Chris Ferrarone note that if margins contract due to rising labour costs, profits will still have the ability to grow as an improving economy drives more volume to corporations.
Labour market trends, particularly compensation costs, are critical drivers of profitability. As Chart 4 shows, there are strong linkages between compensation and profits. It’s no coincidence that labour market formation in the US over the last few quarters has been followed by a pick up in unit labour costs (Chart 5) and a peaking in profit margins.
It’s also no coincidence that equity markets have moved higher over the last several months. As we’ve noted several times recently, the improvement in the global growth backdrop has been a critical support for equities. Improving labour markets – and income growth – while not great for corporate profitability, do support a continued recovery in consumer spending and stronger business confidence. These are critical features for a more sustainable economic backdrop that can translate to lower risk premia and higher valuation multiples and support equity returns in the face of slower growth.
Here’s one of the more counterintuitive charts you’ll ever see:
The income growth argument is not unique to UBS. Deutsche Bank economist Carl Riccadonna recently argued that income growth is actually more important than job growth, which has been disappointing lately.
Ferrarone warns that earnings growth tend to decelerate and stock markets typically exhibit turbulence during these periods of profit contractions. But overall, it seems shrinking margins caused by rising labour costs can be more good than bad.
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