Be wary of wide margins

So is the panic over?

At the end of last year, stock markets around the world were looking very shaky.

The FTSE 100 was down almost 17% from its May-2018 peak, the S&P 500 was within a touch of a bear market (i.e. it had fallen nearly 20%), European markets were on the slide and China was continuing its year-long downswing.

Since since then the US Federal Reserve – the biggest market mover around – has gone ‘dovish’ on monetary policy. In practical terms, this means American interest rates will be lower than previously expected while liquidity will be higher.

At the moment, that’s seen as beneficial for both US and global stock prices. Indeed, the Fed’s shift has been a game changer in sparking the 2019 worldwide equity market rally (I wrote about China recently). (

But a worldwide economic growth slowdown is currently underway. For investors, that means this isn’t a time to be complacent…

What’s driven stock prices higher?

Global stocks soared after their great financial crisis-driven March-2009 low.

You know that. But what actually caused the subsequent bull market?

Here are some interesting stats from the analysts at Goldman Sachs.

Over last decade, around half the 300% surge in US stock prices has resulted from earnings increases. Valuation expansion, in other words rising price/earnings ratios, has propelled the other half of this rise.

That’s a huge contrast with Europe whose much lower equity market performance (+111% in US dollar terms over 10 years) was solely driven by higher valuations (it’s amazing to see that Europe has seen no earnings growth when measured in US dollar terms during the past decade).

Here’s the chart that illustrates this (for which thanks to Goldman: APxJ is Asia Pacific ex Japan and pp is percentage points):

Goldman has also split earnings expansion (except in Europe, on balance) into sales or margin changes. And it turns out that margin widening has created more than 60% of profit growth in both the US and in Europe (where applicable). In contrast, during previous economic cycles, more than 70% of the rise of company profits was accountable to higher revenues.

Over the last decade, US margins have improved by about 280 basis points (bp, i.e. 2.8%) versus than their pre-financial crisis peak, compared with just 40bp for profit margins in Europe (again, where there have been profit increases). This translates into S&P 500 index earnings per share (EPS) at 86% more than their pre-crisis level while European EPS in local currency terms are just 7% above their pre-crisis peak.

Where is this going?

A serious problem is looming. Profit margins in the US are well into all-time high territory at more than 11%. They even topped 12% in 2018’s third quarter. And despite the lack of recent widening, in Europe they’re still standing at a comfortable 7.6%, almost as high as they’ve ever been.

If the world is heading into a period of slower economic growth, which business surveys clearly suggest it is, while pay packets pick up pace, corporate profit margins are likely to move in one way only.

Not up.

Europe has a particular issue here. Its business environment is highly-regulated. Union and government pressures are unlikely to allow corporations to make more money as social tensions increase in tougher economic times. A European margin squeeze is much more likely.

Has margin shrinkage started?

Indeed, some margin shrinkage may have already begun. In the US, operating profit margins for S&P 500 stocks in 2018’s final three months fell to 10.9% from that Q3 12% I mentioned earlier.

Market optimists will no doubt cite the newly-dovish Fed as supportive of current valuations. They may be correct on that score, at least for the moment.

But company earnings, in particular profit margins, still hold the key to the long-term direction of share prices. Both tend to rise and fall together.

“Admittedly, the S&P 500 has sometimes gone up in the past when earnings have failed to grow”, notes John Higgins at Capital Economics.

“But in the vast majority of cases, this has occurred only briefly at the outset of an economic expansion. Investors have then anticipated a future rebound in earnings after a decline during the prior recession.”

Take the 1980s (I remember them well!)

The valuation of the S&P 500 index had plunged to a low level by summer-1982 following significant monetary policy tightening that was intended to crush high inflation in the aftermath of the two oil price shocks. And despite the inability of corporate earnings to recover after two recessions in the early years of the decade, US equities – along with global stocks – had a wild party between 1982 and 1987.

“We are at a totally different stage of the cycle today”, says Higgins. “The economic recovery in the US is nearly a decade old and close to the longest on record. There is therefore little spare capacity to fuel growth. Instead, it is likely to slow sharply this year in response to a prior tightening of monetary policy and fading fiscal stimulus. We expect growth elsewhere, where S&P firms make more than 40% of their sales, to ease further too.”

It’s all pointing to decreases in corporate profit margins. As a result, a substantial earnings contraction could be on the way. In turn that’s set to hit equity prices.

Capital Economics forecasts that the S&P 500 index will end 2019 about 18% below its current level. UK shares haven’t performed as well as in the US in recent times, so they may have less downside. Yet the overall risks are similar.

This is not a time to be a complacent investor.

Over at Strategic Intelligence we’ve been warning for many months about the potential dangers to your portfolio from slowing economic growth. And we’re suggesting ways to counter these threats. To read more of our analysis and get access to all our latest research, click here.

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