It’s official: with the best earnings season since 2010 now essentially over, the numbers are in and S&P500 profit margins are at an all time high of 11.2%.

And yet, as turmoil spreads abroad, while capacity bottlenecks and rising wage pressures grow domestically, and with business tax cuts now behind us, Goldman Sachs ask if the rapid rise in profit margins can continue.

To answer that question, the bank first looks at corporate profits as a share of GNP, as reported in the national income and product accounts (NIPA), and notes that they have been significantly softer recently than S&P 500 profit margins. As the chart below shows, while NIPA margins exceeded S&P 500 margins until early-2015, they are now 1.25pp below S&P 500 margins.

Furthermore, as seen above, NIPA margins have often led S&P 500 margins. Should we therefore expect weaker S&P 500 margins given the softer recent NIPA margins growth?

The answer, it turns out, is most likely yes: while NIPA data are revised, turns in real-time NIPA margins have often preceded turns in S&P margins. The four S&P “margins recessions” – defined as a decline in the 4-quarter moving average of the profit margin that lasts at least two quarters and features at least a 0.5pp cumulative decline – on record were all preceded by NIPA margin recessions, likely reflecting the higher sensitivity of small firms’ margins to changes in  interest rates and wages. However, one key difference with the past is that highly productive superstar firms with significant pricing power now comprise a very large share of S&P profits, but remain a smaller share of NIPA profits.

Why do NIPA profit margins often lead those of the S&P 500?

According to Goldman, the most plausible explanation is that small firms, which make up a larger share of the NIPA sample, have higher sensitivity to changes in interest rates and wage growth. While small businesses rely on short-term, floating-rate bank loans, large firms borrow primarily from public debt markets at fixed rates. Additionally, small firms’ profit margins are also more exposed to faster wage growth, as their payroll costs are a much larger fraction of sales. Firms with sales less than $100M have an average compensation-to-sales share of 23%, compared to only 12% for firms with sales above $100M.

In other words, if relying solely on the historical relationship, S&P 500 profit margin growth is likely to slow.

However, as Goldman cautions, one key difference with the past is the rise of “superstar firms”. While rather self-explanatory, superstar firms are defined as large and highly productive firms with significant bargaining power over consumers and workers as a result of product and labor market concentration. Superstar firms now comprise a large share of S&P 500 margin growth, while they still remain a smaller share of the broader NIPA profits

And here Goldman makes a striking revelation: as shown in the chart below, the information technology sector – which contains the bulk of superstar firms accounts for 60% of the increase in S&P 500 profit margins over the past 20 years, while the “adjacent tech” sector, comprising the health care (including biotech firms) and consumer discretionary sectors (incl. firms such as Booking Holdings and Expedia) accounts for 40% of the rise.

It also means the bulk of the market – i.e., all firms ex. tech, healthcare and consumer discretionary – have seen no margin growth at all since 1998!

The good news is that continued outperformance of superstar firms could lead to continued S&P 500 margin growth through two channels.

First, a further rise in the total S&P 500 sales share of high margin firms would boost margins via a composition effect. Second, the higher sales-to-compensation ratio and wage setting power of superstar firms can dampen the downward cyclical pressure on margins.

On the other hand, recent “superstar” scares such as Facebook and Twitter in the US, and Tencent and in China, could be a leading indicator that the relentless margin expansion among the tech sector could be coming to an end.

If that is the case, and with NIPA margins suggesting further downside to the S&P bottom line, what is the outlook for margins from here onward?

In its evaluation, Goldman next looks at three alternative scenarios which feature different paths for unit labor costs, foreign growth, interest rates, and the dollar, but all assume core PCE inflation modestly overshoots to 2.3% by end-2019. Goldman also notes that since “the near-term recession odds are relatively low, we don’t consider an outright economic recession scenario.”

The resulting scenario, whose key assumptions are laid out above, are as follows:

Wages warm up:

We assume a hot labor market where (1) wages rise 1 percentage point faster than expected by mid-2019 and (2) the Fed hikes the funds rate twice a quarter in 2019 H2. Profit margins already peak this year and are 1pp lower by end-2020 than in the baseline. Higher wage growth and higher interest rates both weigh significantly on nonfinancial corporate margins because compensation accounts for almost 60% of gross value added and because leverage is now about 20% higher than in 2005.

Turmoil abroad:

We assume turmoil abroad causes (1) a 1.25pp miss in foreign growth, (2) a 0.4pp miss in US growth (reflecting the hit to exports, for instance in a severe trade war), and (3) the Fed to hike two times less than in our baseline. Profit margins end up 0.4pp lower by end-2020 than in the baseline. The drag on NIPA margins is significant but not enormous as rest-of-the-world profits account for less than 25% of total NIPA corporate profits and as lower interest rates soften the blow.

Superstars surge:

We assume (1) a 1pp beat in productivity growth along with (2) still moderate baseline wage growth, possibly reflecting the further expansion of superstar firms. NIPA profit margins rise by 0.75pp to an all-time high of 10.8% by end-2020 as unit labor cost growth continues to run below price inflation.

Goldman’s analysis of the S&P-NIPA margins gap and of the macro-drivers of NIPA profit margins is consistent with the bank’s market forecast that S&P 500 profit margin growth is likely to slow: it forecasts S&P 500 after-tax adjusted profit margins of 11.0% in 2018 (vs. 10.1% in 2017), 11.2% in 2019, and 11.1% in 2020.

However, risks are tilted to the downside as Goldman lays out in its conclusion:

While margins have recently benefited from tax cuts, and exceptionally rapid global growth, these tailwinds are now fading. Further sharp rises in profit margins likely require both continued moderate wage growth along with rapid productivity growth, for instance driven by the continued outperformance of superstar firms.

An abbreviated version of above reads as follows: it’s all about the “superstar” tech companies, those which in the past 20 years have accounted for 60% of overall profit margin growth since 1998.

Should an unexpected event occur, and breach the steady upward sloping status quo, it’s not just the market – where professional investors are highly concentrated in just a handful of tech names – that gets it, but so does the economy as margin collapse in what some may say is a long overdue mean reversion.

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