Markets

Stephen Gandel is a Bloomberg Gadfly columnist covering equity markets. He was previously a deputy digital editor for Fortune and an economics blogger at Time. He has also covered finance and the housing market.

Jamie Dimon, the CEO of the nation's largest bank, JPMorgan Chase & Co., has turned out to be no Donald Trump lap dog. He joined the president's CEO advisory council, but he's also reportedly challenged the president as well. He told Trump in a meeting with other business leaders that he didn't think China was a currency manipulator, which had been one of Trump's more persistent campaign talking points.

Earlier this year, though, at JPMorgan's annual investor day, Dimon gave a full-throated defense of Trump's expected corporate tax cut proposal. Dimon said it wasn't about boosting corporate bottom lines or the profits of banks like his. Instead, the corporate tax cut was needed for American workers.

"It about capitalism," Dimon said. "Lower taxes are not going to mean that businesses are going to have forever higher profits. It's going to go somewhere. And though it sounds counterintuitive, studies show that the thing that is impacted the most from lower corporate tax rates will be wages." Dimon reiterated the argument in more detail in his annual letter to shareholders.

Higher for Longer
Profit margin of the S&P 500 by decade
Source: Bloomberg

But a piece out this week from a prominent investor suggests that while Dimon may have been right in the past, a significant shift most likely means that benefits of corporate tax cuts won't be all that diffuse this time around. The investor, Jeremy Grantham, co-founder and chief investment officer of GMO, argued in his quarterly letter to shareholders that this shift has significant implications for investors and the stock market. In the letter, Grantham acknowledges that while "this time is different" logic can be dangerous, assuming "that things are never different" can be ruinous as well.

Dimon's argument is Econ 101. In a free market, excess profits should be competed away, either through higher costs or pricing pressure. One of those rising costs is likely to be wages. And in his annual letter, Dimon cites a study by conservative economist and co-author of the Dow 36,000 prediction, Kevin Hassett, which found that a $1 increase in corporate taxes leads to as much as a $4 drop in wages.

But Grantham contends recent data suggests that's not how things have been working. Excess profits have not been competed away. The opposite has been true. Corporate profit margins are near historic highs and have been for a while. By GMO's data, return on sales has been above 8 percent for most of the past six years and as high as 10 percent. It used to average 5 percent. A factor of that has been what has been dubbed the current wageless recovery.

Grantham cites a number of reasons for this. Globalization has given brands, particularly American brands, a wider reach and more power. Consolidation has made companies both more dominate in the marketplace and in Washington, getting more of what they want. And paradoxically, Grantham says, even when corporations and their lobbyists have lost, it has still worked in their favor. Regulations meant to protect consumers have actually made it harder for smaller firms to compete and easier for large established firms to hold on to their market share. All of those reasons suggest that excess profits from lower taxes or another source aren't likely to be quickly siphoned away, to workers or consumers or elsewhere.

Up and to the Right
The performance of the stock market has confounded bears
Source: Bloomberg

Grantham subtly admits the sustained trend toward higher profit margins, and the reasons for it, is something he missed as well and why he has been so wrong for most of the current bull market. For much of the past three years, Grantham has been ringing the warning bell about the stock market, saying it's overvalued and in a bubble. He had been solidly in the camp that profit margins will revert to the mean and take the stock market's higher-than-average valuation down along with it. In mid-2015, he said the market was ripe for a sharp decline in 2016. But about six months ago, Grantham changed his tune.

In the latest quarterly letter, Grantham says profit margins should actually improve this year and next. Oil prices seem to have bottomed and the low profits in the energy business for the past two years creates an easy base for improvement. Trump's tax cut, if enacted, will help as well. But at the very least, Trump will be chipping away at regulation, which will most likely bolster profitability as well.

And as long as profit margins remain high, Grantham says, there is no reason to expect a fall in the market. Grantham calls the odds of a significant decline in the near future "quite low," which is pretty bullish for an investor who has at times preferred timber to stocks and has been called "famously bearish." Let's hope Grantham has picked the right time to be different.

This column does not necessarily reflect the opinion of Bloomberg LP and its owners.

To contact the author of this story:
Stephen Gandel in New York at sgandel2@bloomberg.net

To contact the editor responsible for this story:
Daniel Niemi at dniemi1@bloomberg.net