In brief

  • Diminishing macro fears have driven a market recovery despite a profit slowdown.
  • Margins are at risk due to a cost structure that is rising faster than revenues because sales growth remains below average and pricing power is fading due to technology.

The magnitude of the recent re-rating in equities and spread-tightening in credit markets has been surprising, particularly when considering the prospects for markedly lower profits this earnings season. This is largely due to diminishing fears of negative macro catalysts, namely the trade war and tighter monetary policy. But what impulse will financial markets require to drive future returns?

In a word, earnings.

This business cycle has been above average in length but below average in strength as spending on tangible goods — such as computer hardware or automobiles — has moved from what were once large upfront capex line items to lower and recurring operating expenses, such as cloud computing or ride sharing.

This has led, over the past decade, to a different type of economic and profit cycle than I think most investors have been trained for. Here is how that has played out:

  1. In the years immediately following the global financial crisis (GFC), companies shed costs and restored profitability.
  2. As the cycle matured, the adoption of new technologies resulted in lower-than-normal capital investment, which in turn restrained economic and sales growth.
  3. As the benefits of cost-cutting have waned and with revenue growth remaining weak, companies have resorted to increasing financial leverage through additional borrowing. Balance sheet quality has been sacrificed for the benefit of higher dividends, mergers and acquisitions, and buybacks. As a result, corporations, not investors, have been the largest purchasers of equities over the past five years.

So where does this leave us going forward?

Companies will need to show profit durability if the market is to sustain today’s elevated levels. In order to do so, however, they will ultimately need faster revenue growth because they cannot cut costs forever. That may prove tough, with labour costs rising and financial maneuverability limited owing to today’s leverage levels exceeding their pre-GFC heights. After all, revenue growth can come only from one of two places: selling more units or selling the same number of units at higher prices.

This begs the questions: Would a shift back to freer trade increase demand for healthier or more authentic consumer products at the expense of less healthy, less authentic options? And would easier financing conditions provide a sales lift for brick and mortar retailers that offer goods consumers can find cheaper online?

The portfolio manager believes the answer to both questions is no, and consequently that an acceleration of sales growth is unlikely.

Will companies be able to raise prices?

I believe that gross margins are a good, if imperfect, proxy for pricing power. The illustrations below show the number of companies with increasing year-over-year gross margins in the developed markets. While the charts ebb and flow, there has been a general decline in gross margins during this business cycle. This is not a function of below-average economic growth but rather of an increasing number of companies seeing their value propositions duplicated, most often by Internet platforms.

Exhibit 1: Number of companies with increasing gross margins

Source: Factset. Monthly data from 1 January 2011 to 28 February 2019. The MSCI EAFE (Europe, Australasia, Far East) Index measures the non-US stock market. The S&P 500 Index measures the broad US stock market.

Disappointment without a further catalyst?

The market, at these valuations, seems to have priced in both positive macro and profit outcomes. I believe that margins are generally at risk due to a cost structure that is rising faster than revenues because sales growth remains below average and pricing power is fading due to technology.

Because of this, without the impulse of an unexpected improvement in profits or a further reduction in macro headwinds, I fear investors risk disappointment.

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