Margins will fall, but to where?

Good morning. Ethan and I are tanned, rested and ready after a week away. We hope you had some rest over the spring holiday season as well. Stock markets edged higher while we were gone, helped by solid earnings from big US banks on Friday. Last week’s financial data continued to point to a gentle slowdown in activity. We think this earnings season will probably be OK, despite some further tightening of margins (see below). Send us your fearless predictions for corporate results season: [email protected] and [email protected]. 

Margins revisited

Before our spring break, we observed that corporate margins, as measured in the US national accounts, remain extraordinarily high. Higher, even, than the numbers followed most closely by Wall Street — S&P 500 operating margins — would suggest. This is important to any assessment of the economy because margins are a leading economic indicator. Companies fire people when margins tighten, contributing to recessions. Still-high margins suggest that recession may not be imminent.

It is possible to regard today’s persistently high margins as a pandemic effect; Albert Edwards of Société Générale takes this view. Certainly, margins have not been as high as they were in 2021 and early 2022 in a long time. But in the case of US public companies, at least, it looks like the pandemic profit boom might be the culmination of a longer-term trend, rather than a distinct event.

We reach this (very tentative!) conclusion on the basis of a data set sent to us by Chris Mowbray and his team at S&P Capital IQ. It aggregates the profit margins of all public US companies since 1990 (excluding public companies that have no revenue, which can’t be said to have margins; and banks and other financials, for which revenue margins are a bad way to measure profitability). The data set is good because of its breadth and because it avoids survivorship bias: it looks at every US company that existed in each historical quarter, not just the historical margins of companies that still exist.

Here is what margins look like over the last three decades:

One interesting thing here is that in the case of both gross and operating margins, there was a 2021 peak, but it was not very much higher than the highs reached in the preceding 10 years (this is not as true when you look at the S&P 500; very big companies had a sharper spike in margins than all companies in aggregate).

Zooming in on operating margins, it is pretty clear that something happened after the great financial crisis. Through different stages of the economic cycle, margins are higher since 2010:

The crucial question for public company investors is not whether margins will mean-revert from post-pandemic peaks. They very likely will, though the precise timing can only be guessed at. The big question is whether they will revert to pre- or post-GFC levels.

It is natural to conclude that the post-GFC margin spike is somehow explained by monetary policy, given that after 2010 policy rates were pinned down and the Fed balance sheet growing. It is not clear to me exactly how this would work, however (remember operating margins are calculated before interest expense). Furthermore, there are other explanations available. Are companies underinvesting, boosting profits (and management pay) at the cost of future growth? This is the view of the economist Andrew Smithers. Or perhaps industry has become less competitive, allowing companies to pad margins without giving up market share? Or perhaps companies have had the upper hand against workers in recent years? We are keen to hear readers’ thoughts.

$s and £s

For half of 2021 and most of 2022, the US dollar only got stronger. Three great dollar tailwinds — a global energy crisis, the Fed’s pacesetting rate increases and geopolitical risk in Europe — created trough-to-peak appreciation north of 25 per cent. But that was then. Peak dollar strength came in September, and the intervening half-year has brought new forex winners. Here’s an interesting one, from Bloomberg yesterday:

Just a few months ago, it was a no-brainer to bet against the British pound.

Talk about the currency tumbling to US dollar parity was everywhere during Liz Truss’s disastrous premiership. Hardly anyone was optimistic about a country on the brink of its longest-ever recession.

But the bleak views are proving to be overstated, at least for now. The pound has roared back this year, delivering the best performance of any major developed currency [on a total returns basis]. Strategists are turning more positive too, with Nomura, NatWest Markets and HSBC saying the rally will continue.

The Bloomberg story emphasises the UK’s economic resilience in the face of widespread recession calls as the pound’s strength. And that’s certainly part of the story. The euro’s huge rally against the dollar last year reflected a similar pricing-out of the most dire fears. But we figure the pound rally is mostly just the flipside of a dollar dip. For starters, the pound and euro have travelled very close together since the start of the year:

Bloomberg’s numbers measure pound performance on a total returns basis (ie, considering currency moves plus the prevailing risk-free rate), and so are somewhat flattered by the UK’s higher policy rate, which is 75 basis points above the eurozone’s. But look just at currency prices and the pound doesn’t stand out. The chart below shows how far the US dollar has depreciated against currencies included in the widely cited dollar index, since peak dollar strength last year:

There is a simple reason for recent dollar weakening. The Fed is nearing a rates pause, on the hypothesis that US-centred bank stresses will tighten credit conditions and obviate the need for further hikes. Yet a pause looks farther off in the UK and eurozone, where inflation is higher and appears stickier than in the US. In Japan, many think yield curve control will be scrapped soon, letting rates rise. This will mean tighter rate differentials in Europe and Japan, drawing capital out of dollars and into euros, pounds and yen. In contrast, Canada, where rate increases have already been paused, is seeing far less currency appreciation.

The big question in forex: is the dollar’s downturn a shortlived retreat, or the start of something bigger? Capital Economics’ James Reilly thinks the former. He wrote Friday that, besides tighter rate differentials, the other force depressing the dollar is that familiar soft landing, risk-on feeling in markets; remember, US recessions tend to boost the dollar. But:

We don’t think this optimism is sustainable, because investors look guilty of trying to have their cake and eat it as far as disinflation is concerned. Although we agree that inflation will come down and that the end of the Fed’s tightening cycle is imminent, one of the key disinflationary forces supporting this view is a slowdown of the US economy. We expect a mild recession later this year, an outcome which doesn’t look fully discounted in markets. So, as growth across advanced economies disappoints, we expect safe-haven demand to spur a fresh rally in the dollar.

Taking the other side is Calvin Tse at BNP Paribas, who doubts safe-haven demand can overcome what he thinks is a “multiyear structural USD decline”:

the Fed is waiting to see if tighter credit conditions can do the job of rate hikes in slowing the economy, resulting in a fall in US real yields and curve steepening pressures. Coupled with positive yields outside the US and a more hawkish ECB, this should further spur repatriation of funds by European and Japanese investors, who have been overweight US assets for much of the past decade. We expect the rotation out of US debt to continue, as well as a near-term move out of US equities as Value should outperform Growth this year, which would further weaken the USD.

Even in the case of a global risk-off event, we think USD strength from safe-haven demand would be limited after the Fed in March made the standing central bank liquidity swap lines available daily. This highlights that the Fed is acting preemptively, rather than reactively, in handling tight USD liquidity, which should limit any potential dollar surge.

Unhedged doesn’t have a considered view here, so we’ll just add that this looks like the broader market debate in miniature. Sea change or cyclical transition? (Ethan Wu)

One good read

Over at Matt Klein’s The Overshoot, Toby Nangle gives a more detailed version of his argument that asset managers should avoid working for totalitarian regimes.