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Down Under Daily, 27 August 2014

Flat At The Margin


There are hints that US profit margins are at, or Exhibit 3
near, a peak. This will likely be confirmed if labour The Key To Higher Margins: Lower Labour
US DOMESTIC NON-FINANCIAL UNIT COSTS
costs rise. History shows that recessions cause 18 68
equity bear markets, but margins typically peak 16
DEPRECIATION
66

% OF GROSS VALUE ADDED

% OF GROSS VALUE ADDED


beforehand. If margins have peaked, then equity 14 64

returns will be lower, unless valuation keeps rising 12


TAXES*
62

10 60
(which I dont expect).
8 58
LABOUR (RHS)
6 56
NET INTEREST
US profit margins have reached higher highs in each 4 54

of the past four cycles. However, there are now 2 52


* COMPANY TAX PLUS NET INDIRECT TAXES
0 50
hints of a peak in this cycle (Exhibit 1). 1980 1984 1988 1992 1996 2000 2004 2008 2012

Source: BEA, NBER; Minack Advisors


Exhibit 1
Margins Start Flattening Exhibit 3 also shows that taxes and interest
14
US PROFIT MARGINS
* S&P500 OPERATING MARGIN NON-FINANCIAL CORPORATE SHARE OF SALES
14 payments have been flat on a per sales unit basis.
12
DOMESTIC NON-FIN PROFITS (NO CCA/IVA) SHARE OF NON-FIN CORP GDP
12
With tax per unit flat, but profit per unit (margin)
S&P MARGIN*

10 NIPA PROFIT SHARE 10


up, the effective tax rate has fallen (Exhibit 4).
NON-FIN MARGIN
8 8
%
%

Exhibit 4
6 6
Falling Effective Tax Rate
4 4 EFFECTIVE CORPORATE TAX RATE
60 60
2 2 EFFECTIVE TAX RATE
55 FOR NON-FINANCIAL 55
0 0 CORPORATES
50 (BOTTOM UP DATA) 50
1980 1984 1988 1992 1996 2000 2004 2008 2012 2016
45 45
Note: profit share of GDP shown as a rolling four quarter average to be

% RATE
% RATE

40 40
comparable to margin series, which are rolling twelve months. Profit
share is domestic non-financial sector profits, so excludes foreign-sourced 35 35
profits. Both bottom-up margin series include foreign-sourced profits. 30 30
Source: BEA, S&P, DataStream/Worldscope, NBER; Minack Advisors EFFECTIVE TAX RATE ON
25 DOMESTIC NON-FINANCIAL 25
PROFITS (MACRO DATA)
20 20
Bear markets happen in recessions, but profit 15 15
margins often peak before recessions (Exhibit 2). 1980 1984 1988 1992 1996 2000 2004 2008 2012 2016

Source: DataStream/Worldscope, NBER; Minack Advisors

Exhibit 2
Is That The Peak For Domestic Margins? Flat interest charges per unit reflect two offsetting
US NON-FINANCIAL DOMESTIC POST-TAX PROFIT MARGIN
changes: rising corporate leverage versus declining
14
NUMBERS SHOW HOW MANY QUARTERS PRIOR
6Q effective interest rates (Exhibit 5).
12 TO RECESSION THAT MARGINS PEAKED
-3Q 3Q

10 Exhibit 5
8 15Q
Falling Interest Rates
%

CORPORATE INTEREST RATES


6 8Q
18 18
* YIELD TO REDEMPTION ON BARCLAYS AGGREGATE
LONG BAA GRADE CREDIT INTEREST
4
16 PAYMENTS/DEBT FOR NON-FINANCIAL CORPORATES 16

2 ACTUAL RATE PAID


DOMESTIC NON-FINANCIAL SECTOR PROFITS (NO IVA/CCA ADJUSTED) AS SHARE OF 14 14
DOMESTIC NON-FINANCIAL SECTOR GDP. MARKET RATE*
0
12 12
1970 1975 1980 1985 1990 1995 2000 2005 2010 2015
%

Note: profit share is quarterly (current quarter profits/quarterly GDP). 10 10


Source: BEA, NBER; Minack Advisors 8 8

6 6
The most important reason for high profit margins
4 4
is low labour costs. Labour costs are at a multi- 1980 1984 1988 1992 1996 2000 2004 2008 2012 2016

decade low as a share of business costs (Exhibit 3). Source: Barclays, DataStream/Worldscope, NBER; Minack Advisors

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Wednesday, 27 August 2014
Reported profit margins are based on sales, not Second, the rise in EPS has been faster than
value added. Exhibit 6 shows a decomposition of earnings because the equity base has been reduced.
margins for the non-financial listed sector. EBITDA Stock repurchase figures exaggerate the effect
(earnings before interest, tax, depreciation & gross buy-backs are partly offset by option-related
amortisation) margin for non-financials has been stock issuance but net equity issuance has been
flat through the past 30 years. Likewise for the negative since mid-2010 (Exhibit 8).
EBIT margin. The rising trend in after-tax profit
margin reflects lower taxes and interest payments. Exhibit 8
Negative Equity Issuance Lifts EPS
Exhibit 6 US EQUITY ISSUANCE
300 * FLOW OF FUNDS DATA
Margin Decomposition 250
NET EQUITY ISSUANCE*
S&P500 COMPANIES. SIGN
REVERSED.

US NON-FINANCIAL SECTOR PROFIT MARGIN 200


REPORTED BUY-BACKS
20 20 150
EBITDA MARGIN

US$BN
19 19 100
50
18 18
0
17 17
-50
16 16 -100
15 15 -150

14 DEPRECIATION 14 -200
2000 2002 2004 2006 2008 2010 2012 2014 2016
13 13
Source: Standard & Poors, Federal Reserve, NBER; Minack Advisors
12 12
% OF SALES

% OF SALES

11
TAXES
11
Finally, if labour costs have troughed on a cyclical
10 10
basis, then margins have likely peaked. The
9 9
relevant measure is unit labour costs. Unit labour
8 8
INTEREST costs are rising due to increasing wages with a
7 7
smaller-than-usual offset from rising productivity.
6 6

5 5

4 4
The more contentious question is whether this
3 3
marks a longer-term structural turn in wage share.
2 EBIT MARGIN 2 Structural disinflationary forces suggest that wages
AFTER TAX
1 PROFIT MARGIN 1 will remain under pressure. However, the ultimate
0 0 constraint on labour share falling further is the link
1980 1984 1988 1992 1996 2000 2004 2008 2012 2016
to consumer spending (Exhibit 9). A sustained
Source: DataStream/Worldscope, NBER; Minack Advisors
decline in labour income would threaten the
A few follow-on points: First, profit growth in the expansion, which in turn would cut margins.
past cycle has been driven by margins (Exhibit 7).
Exhibit 9

Exhibit 7 The Ultimate Constraint On Labour?


Earnings Growth A Margin Story 74
CONSUMER SPENDING AND LABOUR PAYMENTS

US DOMESTIC CORPORATE AFTER-TAX PROFIT GROWTH 72 CONSUMER OUTLAYS*


20 10 YEAR LABOUR INCOME
SALES VOLUME* PRICE CHANGE* 70
AVERAGE
* PCE PLUS INTEREST PLUS TRANSFERS
68
GDP SHARE %

AFTER-TAX
15 PROFIT EFFECTIVE TAX MARGIN
GROWTH 66
10YR AVERAGE %

10 64
62
5 60
58
0 56
54
-5 52
1950 1955 1960 1965 1970 1975 1980 1985 1990 1995 2000 2005 2010 2015
* THE VOLUME/PRICE SPLIT USES DEFLATOR FOR NON-FINANCIAL SECTOR.
-10
1970 1974 1978 1982 1986 1990 1994 1998 2002 2006 2010 2014 Source: BEA, NBER; Minack Advisors

Source: BEA, NBER; Minack Advisors

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Wednesday, 27 August 2014
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Wednesday, 27 August 2014

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