Margin Meltdown Just Starting Says JPMorgan Citing Hiring SurveyBy
Strategist Matejka sees profit margin shrink 200 basis points
Contrary to consensus that S&P 500 profitability will improve
Don’t look now but the pieces are in place for a margin squeeze that equity bears have warned will snuff out the bull market, according to JPMorgan Chase & Co.
The evidence is in the National Federation of Independent Business survey, which showed companies across a broad swath of American industries are likely to boost wages this year faster than prices rise for finished goods. Such a mismatch is rare and has usually happened right before recessions in data going back to 1986.
A multitude of bear cases for stocks rest on margins, or the portion of sales that translate into earnings. It’s easy to see why: amid a dearth of revenue gains, American companies have reported year after year of earnings growth thanks to their ability to hold down costs such as pay. Margins, the fulcrum between top and bottom lines, reached records in 2014 and hovered near there ever since.
“When margins are beginning to possibly revert to their historic norms, there is fear that it leads to less earnings for companies and shareholders aren’t going to keep paying up,” said Bill Barker, a money manager who helps oversee about $1.5 billion at Motley Fool Funds in Alexandria, Virginia. “Sales are not growing and you can only have earnings to the degree that profit margins allow.”
Based on the trends in the labor market and gross domestic product, JPMorgan strategists led by Mislav Matejka predict margins may contract 2 percentage points this year. Such a narrowing would be particularly ill-timed with bulls pinning hopes on improving profitability to help reverse a decline in Standard & Poor’s 500 Index earnings.
Among S&P 500 firms, profit margins have more than doubled since 2009, reaching a record of 9.37 percent in the third quarter of 2014, data compiled by S&P Dow Jones Indices show. While the measure of profitability has since slipped, analysts surveyed by Bloomberg view the decline as temporary, projecting wider margins this year will spur a rebound after profit suffered in 2015 amid plunging oil and surging dollar.
JPMorgan’s study suggests the optimism is misplaced. Viewing the hiring survey as a rough indication of what will materialize in public companies in terms of sales and expenses, the outlook for profitability dims.
For the first time since the 2008-2009 global recession, the net percentage of firms with plans to raise wages in the next three months outnumbered those with plans to boost prices, according to NFIB’s survey of small businesses. The spread reversed a six-year trend of higher price expectations, falling below zero from September to November. It stayed at zero last month, the latest survey released on Jan. 12 showed.
While the sample is small, history suggests that readings below zero have boded poorly for margins. Over the last three decades, the wage-price spread had turned negative on two occasions outside economic recessions, in 1986-1989 and in 1996-1999, data compiled by Bloomberg and JPMorgan show. In both cases, profit margin kept shrinking amid persistent pressure from higher wages.
In the classic cycle, margin contractions don’t last until an economic acceleration convinces companies to boost hiring and capital spending beyond what sales warrant. That’s unlikely today because growth is too slow and companies are cautious about raising wages, according to Andrew Slimmon, Chicago-based portfolio manager who helps oversees $5.1 billion at Morgan Stanley Investment Management.
“It’s unclear to me if profit margins declining are necessarily going to cause this big disaster that everyone thinks they will,” Slimmon said. “I don’t believe in this big economic recovery so I’m dubious how much wage growth we’ll truly have. Corporate managers have been very stingy.”
JPMorgan’s Matejka calculates corporate profit margin, based on National Income and Product Account data provided by the U.S. Department of Commerce. While the so-called NIPA margin is at best a rough guide for the S&P 500 since the latter represents the largest American companies with more leeway in managing costs, the two have shown similar trends historically.
The damage of lower margins was visible in S&P 500 profits during the 12 months through September. Over the period, the measure of profitability narrowed by about 120 basis points and the quarterly profit drop accelerated to 3.1 percent.
Analysts surveyed by Bloomberg estimated sales will rise about 4 percent in 2016 and, with the help of a margin increase of 33 basis points, profit will climb 7 percent.
Under that revenue scenario, S&P 500 profit growth turns negative should margin narrow by 40 basis points. The decline would worsen to 1 percent if margin fall by 50 basis points and 6 percent should the contraction reach 100 basis points.
|EPS||Sales per Share||Margin|
|2015 analyst estimates||$116.7||$1,100||10.61%|
|2016 analyst estimates||$125||$1,143||10.94%|
|change vs. 2015||7.1%||3.9%||0.33%|
|how much it takes for lower margin to wipe out profit growth?|
|2016 new estimates||$116.7||$1,143||10.21%|
|change vs. 2015||0%||3.9%||-0.40%|
Tobias Levkovich, chief U.S. equity strategist at Citigroup Inc., said the price-wage gap tends to lead corporate profit margin by two years. The fact that it has turned down suggests a “reason for caution’’ next year, he wrote in a note to clients Thursday.
JPMorgan studies market and economic cycles since World War II and found that on average, the peak in profit margin came five quarters before the end of the bull market and seven quarters before the start of an economic recession.
“We are concerned that the positive drivers of profit margins are getting exhausted,” Matejka wrote in a note published last week. “If margins have really peaked, the next downcycle is getting nearer.”
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