Marginal improvement

THE past four years have been bad for workers and savers but good for the corporate sector. Profit margins in America are higher than at any time in the past 65 years. That helps explain why the equity market has rebounded so strongly despite a lacklustre economy.

Margins have been boosted by firms' tight control of labour costs and by a reduction in interest expenses caused by the policies of central banks throughout the rich world. Whether such margins can be sustained is important for equities.

Most stockmarket bulls build their case on the trailing price-earnings ratio for the S&P 500, which stands at 16. But there is a warning sign in the cyclically-adjusted p/e (which averages profits over ten years). At 22, this ratio is well above the historic mean, making the market look a lot less attractive.

Theory would suggest that profit margins will revert to the mean over time. If profits are very low then companies will go out of business, improving the competitive position (and thus the margins) of those businesses that survive. Similarly, if profits are high then more capital will be attracted into the industry (and existing businesses will be tempted to expand) and the resulting competition will cause margins to fall.

However, the current high level of profits is not leading to a surge in investment. As a proportion of GDP, American business investment is close to 30-year lows. This shortfall has been blamed on many things, from over-regulation in America to uncertainty about the outlook for demand when real incomes are being squeezed by higher fuel prices and the lack of wage growth.

Peter Oppenheimer of Goldman Sachs points out that the high profit share of GDP is simply a corollary of the low share taken by labour. “With high unemployment and further substitution of technology for labour, it is unlikely that this will change dramatically any time soon,” he says.

So the cash is going on other things. Robert Buckland of Citigroup says both American and European companies are choosing to spend their cash on mergers and share buy-backs rather than capital expenditure. As a consequence “while profits remain sensitive to the economic cycle, those waiting for the structural mean reversion in margins will continue to be disappointed,” he says.

Andrew Smithers of Smithers & Co, a consultancy, believes that executives are given incentives to boost margins in the short term at the expense of long-term value for shareholders. Pushing up prices boosts profits quickly, for example, but at the risk of losing market share over time. Similarly, executives might not begin a programme of investment that is vital for a company's long-term health because of the effect on earnings per share. Woe betide any company that misses its quarterly earnings target.

If Mr Smithers is right, investors may be overpaying for current profits. The earnings forecasts of American equity analysts imply an increase in margins from current elevated levels, since they show earnings growing much faster than nominal GDP. Of course, to the extent that companies sell goods to the emerging markets, the profits of quoted companies can grow faster than domestic GDP. But that requires investment to keep the corporate sector competitive, and capital expenditure has not been happening on a sufficient scale.

Governments would like companies to start spending their cash piles. But as James Montier of GMO, a fund-management group, points out, that depends on their own behaviour. In terms of national accounts, massive government deficits are a counterpart to the surge in corporate profits. The surpluses and deficits of the various sectors of the economy (government, households, foreign and corporate) must balance, so a huge surplus in one sector must be balanced by deficits elsewhere. Governments spend money on goods and services (that are bought from the corporate sector) or borrow money to finance social benefits, which are then also spent on goods and services from the corporate sector.

This is not to suggest that chief executives should wish for permanent government deficits. But it does suggest that, as those deficits fall, profits might come under pressure. There is a “good” way that this could happen, as companies recruit more staff and pay higher wages, boosting tax revenues. But there is also a “bad” way for it to happen, if austerity programmes cause a slump in demand. Pray for the first outcome.

^{Economist.com/blogs/buttonwood}