Friday, April 13th, 2012
by Neel Kashkari, Head of Equities, PIMCO
- Stock prices today are anchored on strong profits, hence investors’ intense focus on the sustainability of those profits. If they fall, stock prices are likely to follow.
- No doubt individual companies and individual sectors will face margin pressure. But for the equity market as a whole, our central scenario is for corporate margins to remain strong in the near future.
- As always, we are buying individual companies we like based on our analysis of their own fundamentals in the context of the economic environment they are operating in, and we are keeping one eye focused on managing downside risks.
We’ve all heard the story of Sir Isaac Newton sitting in his garden pondering the universe when an apple fell from above and supposedly smacked him in the head. It is said to have been a Eureka! moment when Newton first asked the fundamental question: Why? Why did the apple fall? For centuries people had seen objects fall, but Newton was the first to question what the rest of humanity had just accepted for thousands of years. Today Newton’s question seems obvious – but the most powerful ideas are usually obvious after someone points them out. Newton’s ability to see through the common beliefs of those around him and spot something important is a trait shared by scientific visionaries over the centuries – and one that the most successful investors have occasionally exhibited.
Newton’s questioning of nature led to his development of fundamental laws of physics that have transformed our understanding of the universe. Indeed, in many ways Newton’s ideas have become our own common beliefs similar to those that Newton so brilliantly looked past in his own time. Newton’s Laws, as they are called, are taught in introductory physics classes worldwide:
- A body at rest tends to stay at rest. A body in motion tends to stay in motion.
- Force is equal to the product of mass times acceleration.
- For every action there is an equal and opposite reaction.
These simple rules permeate our beliefs about how the world works and we often don’t realize it. When people say “what goes up must come down,” they are implicitly referring to Newton’s Second Law: In the presence of earth’s gravity, a mass will always accelerate in the direction of that force. Hence, an apple thrown in the air (or grown on a tree) will eventually fall to the ground.
These Newtonian beliefs also affect how many people think about investing. “Mean reversion” is the investment world’s version of “what goes up must come down.” It’s usually a pretty good rule. Mean reversion suggested that the extraordinary price to earnings multiples of technology stocks in the late 1990s couldn’t last; they would eventually revert to historical average valuations. Similarly, mean reversion suggested that house price increases in the U.S. in the mid-2000s weren’t sustainable. They didn’t last either.
But is mean reversion always right? In 2000 mean reversion would have suggested the bull market for bonds would be over. Interest rates couldn’t stay low, let alone fall further, could they? But here we are in 2012 and we’re not predicting a bear market any time soon.
In tension with mean reversion is Newton’s First Law: A body at rest tends to stay at rest. In investment parlance there needs to be a catalyst to force the system to revert to the mean. Left alone, it may continue in its elevated state for a long time.
The timing of that reversion matters: Just because someone can identify a bubble doesn’t mean they can make money from their insight. People who shorted tech stocks too early may have lost a lot of money while the bubble kept expanding.
Today many equity investors are asking whether corporate profit margins can stay strong. Coming out of the financial crisis, many large corporations, especially multinationals, have enjoyed record profits. This is counterintuitive given the low growth much of the developed world has experienced during this time. Corporations responded to the financial crisis by paying down debt and cutting costs, positioning them for strong profit growth as their end markets slowly recovered. Figure 1 is a chart of corporate profit margins, earnings multiples and the overall level of the S&P 500.
Global equity markets have climbed 6.5% year to date (source: MSCI World Index through 11 April 2012). With record profits, earnings multiples still seem reasonable at 14.5 times. Stock prices today are anchored on strong profits, hence investors’ intense focus on the sustainability of those profits. If they fall, stock prices are likely to follow. To assess the vulnerability of profit margins, let’s review several possible catalysts for profit mean reversion and consider how likely they are to occur:
1. Increase in Cost of Labor
Labor costs are about 70% of the total cost of production for corporations, according to Federal Reserve research. There is no question that if competition for a finite labor pool increased, this could put immediate pressure on corporate margins. However, in the U.S. unemployment remains high, stuck at 8.2% as of March 2012, with 14.5% of Americans either out of work or looking for more work (source: Bureau of Labor Statistics). Obviously individual industries and companies may experience wage inflation due to scarcity of workers with specialized skills, but until unemployment falls closer to more normal levels, corporate margins do not appear vulnerable from a spike in unit labor costs. Last week’s disappointing jobs report highlights labor’s slow recovery.
2. Economic Slowdown or Recession
Clearly if the U.S. or world economy were to meaningfully slow or fall into another recession, corporate profits and stock prices would suffer. Our base case continues to be a muddle-through scenario of low growth while avoiding recession in the U.S. and globally (though we do forecast a recession in Europe due to their fiscal crisis and policy response). Certainly a disorderly unraveling of the eurozone, an oil price shock or a hard landing in the emerging markets could tip the global economy into recession, but that is not our central scenario.
3. Dollar Strengthening
Strong appreciation of the dollar would make U.S. exporters less competitive, which would certainly affect their margins. But companies producing goods and services abroad for sale in America would benefit. Our base case scenario is for a long-term secular decline of the dollar, which assumes continued strengthening of emerging market economies and a Europe that muddles through its fiscal crisis. If either proved incorrect, they could trigger a global recession, which would have a larger impact on corporate margins than dollar strengthening alone.
4. Cost of Capital Increase
If costs for corporations to borrow or to raise equity capital increased substantially, corporate margins would be vulnerable. Corporations today on average have low net leverage with record cash of some $2.23 trillion, according to Federal Reserve data. Climbing rates could pressure corporate margins. They could also push companies to grow more slowly or even contract their activities. Again, this is not our central forecast. We believe the Federal Reserve will stick to its forecast of maintaining exceptionally low rates until at least late 2014, and we believe the European Central Bank will be forced to continue aggressive monetary stimulus to combat its fiscal crisis. It is worth noting that corporations could in fact increase their net leverage from today’s conservative levels, which could actually boost corporate margins.
5. Increased Corporate Taxes
If the federal government increased effective taxes on corporations their net margins would obviously fall. But this appears highly unlikely in today’s political environment. Both Democrats and Republicans are advocating various policies to boost job growth, including pro-growth corporate tax reform. The most common tax reform proposals are revenue neutral, lowering marginal corporate tax rates in exchange for eliminating loopholes and deductions. Policy theory suggests a simpler, fairer tax code should encourage investment and enhance economic competitiveness. While political winds can change direction, as long as unemployment remains high, politicians will be cautious about increasing barriers for corporate investment.
None of these catalysts for profit mean reversion appears likely in the near future, though each is impossible to rule out. Given the importance of corporate margins on today’s stock prices, it is worth taking this review further and also considering a macroeconomic perspective on margins.
Some investors have used the Kalecki profits equation to break corporate profits into its fundamental macroeconomic elements, specifically:
Profits = Investment – Household Savings – Government Savings – Foreign Savings + Dividends
From this equation, investors can see that corporate profits have expanded to such a large share of GDP due to large government deficits. Therefore, if the government implemented a deficit reduction plan, corporate profits could suffer.
Let’s explore this scenario in more detail. We know that Washington D.C. is currently dysfunctional and that large deficit spending is ultimately unsustainable. However, if Republicans and Democrats can agree on anything, it is to keep spending. This is the reason Washington hasn’t produced a new Federal budget in three years – they have simply agreed to extend the status quo. Hence the dysfunction of Washington suggests no meaningful deficit reduction agreement in the near future. Don’t forget that President Obama and both Congressional Republicans and Democrats were united in their dismissal of the serious Simpson-Bowles deficit reduction plan.
Let’s say the tone in Washington does somehow change and consensus is reached to bring the Federal budget into balance. Policy analysts of both parties know that long-term deficits are being driven by demographic changes and the long-term expansion of entitlement programs for our aging society. As with Simpson-Bowles, any major deficit reduction agreement would almost certainly phase in slowly, over many years. Even though current law prescribes a fiscal cliff at the end of this year due to last year’s temporary budget and debt ceiling extensions, Washington will almost certainly agree to delay this deadline. It is hard to imagine an abrupt fiscal adjustment happening in the near future.
If there were a long-term grand bargain, it is true federal government deficits as a percentage of GDP would likely fall, but such a scenario would almost certainly be a net positive for confidence in our economic and political systems and provide a strong tailwind to economic activity. Even if corporate margins fell as federal budgets gradually came into balance, it is easy to imagine corporate profits continuing to grow. It is ultimately the dollars of profit, rather than margins, that drive the value of companies. It is hard to see corporate profits, or stock prices, falling because of long-term fiscal discipline.
These considerations all suggest corporate profits are not on the verge of collapsing. In fact, we are optimistic corporations, on a case-by-case basis, can even continue to improve them through the adoption of new technologies. As always, we are buying individual companies we like based on our analysis of their own fundamentals in the context of the economic environment they are operating in, rather than buying sectors or the market as a whole. No doubt individual companies and individual sectors will face margin pressure. But for the equity market as a whole, our central scenario is for corporate margins to remain strong in the near future. Profits are strongly correlated to nominal GDP. The Federal Reserve’s commitment to lowering unemployment through aggressive monetary stimulus should support both nominal GDP and corporate profit growth.
As we’ve written in the past, we are keeping one eye focused on managing downside risks in our equity portfolios. Serious risks from Europe remain, and at some point the Federal Reserve will have to end its aggressive easing policy. We are still living in a bimodal world, but we are finding good companies today at attractive values that are selling into higher growth markets. We prefer those with strong balance sheets that are paying healthy dividends.
Given the investment analogies of Newton’s First and Second Laws, you may be wondering if there’s an investment analogy for Newton’s Third Law: For every action there is an equal and opposite reaction? Yes: There is no free lunch. That’ll be the subject of a future Equity Focus. In the meantime, be wary of predictions of falling apples (I’m talking about the fruit).
Past performance is not a guarantee or a reliable indicator of future results. All investments contain risk and may lose value. Equities may decline in value due to both real and perceived general market, economic, and industry conditions. Investing in foreign denominated and/or domiciled securities may involve heightened risk due to currency fluctuations, and economic and political risks, which may be enhanced in emerging markets. There is no guarantee that these investment strategies will work under all market conditions or are suitable for all investors and each investor should evaluate their ability to invest long-term, especially during periods of downturn in the market.
The MSCI World Index is a free float-adjusted market capitalization weighted index that is designed to measure the equity market performance of developed markets. The MSCI World Index consists of the following 24 developed market country indices: Australia, Austria, Belgium, Canada, Denmark, Finland, France, Germany, Greece, Hong Kong, Ireland, Israel, Italy, Japan, Netherlands, New Zealand, Norway, Portugal, Singapore, Spain, Sweden, Switzerland, the United Kingdom, and the United States. The S&P 500 Index is an unmanaged market index generally considered representative of the stock market as a whole. The index focuses on the Large-Cap segment of the U.S. equities market. It is not possible to invest directly in an unmanaged index.
This material contains the opinions of the author but not necessarily those of PIMCO and such opinions are subject to change without notice. This material has been distributed for informational purposes only. Forecasts, estimates, and certain information contained herein are based upon proprietary research and should not be considered as investment advice or a recommendation of any particular security, strategy or investment product. Information contained herein has been obtained from sources believed to be reliable, but not guaranteed. No part of this material may be reproduced in any form, or referred to in any other publication, without express written permission. ©2012, PIMCO.
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