In the last few years, the extraordinary policy measures of major central banks – especially the US Federal Reserve (the Fed) – have provided enormous support to share prices globally. Short-term interest rates close to zero and historically low bond yields have encouraged investors into higher risk assets, like shares, in search of higher returns.
Central banks’ actions have also contributed to stronger economic growth and therefore an improvement in corporate profits. This has been particularly important as the other arm of macroeconomic policy – fiscal policy – has largely been working in the opposite direction.
But gains in corporate profits haven’t kept pace with rising share prices. PE ratios at the end of 2013 suggested that world share markets were fully valued at best, and in some cases overvalued. However, elevated PE ratios may well be justified if markets are simply doing what markets tend to do, ie price in the likelihood of further gains in corporate profits.
So are more gains in corporate profits likely?
There are two important points. First, margins are very cyclical and over time, tend to revert to an average level. High profit margins encourage expansion in capacity which competes away excessive margins. Where high profit margins reflect high unemployment and subdued labour costs, that advantage diminishes as labour markets improve and the bargaining power of labour increases.
The second is that while margins in the US and in Japan are at or close to historic highs, margins elsewhere (the UK and eurozone) aren’t. The same pattern appears in economy-wide measures of profitability, like the share of corporate profits in GDP. There seems to be scope for margins to expand in Europe and the UK, if and when economic growth improves. Certainly, the economic data from those economies have improved.
But the US still accounts for around 40 per cent of the world’s shares by market capitalisation. US margins have widened for a number of reasons, both structural (eg the increased importance of the relatively high margin technology sector) and cyclical (extraordinarily low interest rates and the impact of high unemployment on labour costs).
In addition, US profit margins have been boosted by a relentless focus on cost control by US firms and lower energy prices due to the shale gas boom. The widening in margins has been critical to the profitability of US firms, particularly during a period when revenue growth has remained somewhat subdued, in keeping with the generally anaemic state of global demand.
The fact that 40 per cent of the global shares universe is priced at a premium price earnings multiple, at a time when sales revenue growth is modest, suggests the best news on corporate profitability just might be behind rather than in front of us. This should be a cause for concern for investors.
Will returns from US and global shares be affected?
Possibly, but downward pressure on margins may be some time coming. Usually tighter monetary policy in response to building inflationary pressure triggers a fall in margins. This is because the inflationary pressure tends to manifest itself in rising labour costs, tighter policy weakens sales revenue, and firms are unable to reduce costs fast enough – at least in the short term. However, despite a substantial fall in US unemployment, the labour market isn’t strong enough to produce wage pressures that would trouble the Fed.
And despite the Fed starting to taper its QE program, US monetary policy will remain extraordinarily loose for some time. Not only could this push out the next policy-induced recession, but persistently low interest rates still give investors an incentive to seek higher returns in shares.
So the usual “cyclical” culprits responsible for lower profit margins and weaker returns from shares may not show up soon. If this scenario plays out, US share market returns could remain pretty solid, despite signs that the market is overvalued. As history has shown many times, markets can remain overvalued for some time, particularly if liquidity conditions remain supportive, as they still are. Asset allocators relying solely on valuation nearly always have to be patient – as do their clients.
