Multi-Asset

United States

Corporate profit data (whole economy) has now been released for the final quarter of 2017.
April 2018

Risk Disclaimer

Views and opinions expressed by individual authors do not necessarily represent those of BMO Global Asset Management and should not be considered to be a recommendation or solicitation to buy or sell any companies that may be mentioned.

Corporate profit data (whole economy) has now been released for the final quarter of 2017. It confirms the impression that profit growth has stalled and profit margins are gradually weakening. In fact, on a quarterly basis, pre-tax profits reached a peak in the 4th quarter of 2014 whilst margins peaked in the 3rd quarter of 2014.

US: Pre-tax Corporate Profits

(Quarterly at annual rates – billions of dollars)

Source: Thomson Reuters Datastream

 

Risk Disclaimer

Views and opinions expressed by individual authors do not necessarily represent those of BMO Global Asset Management and should not be considered to be a recommendation or solicitation to buy or sell any companies that may be mentioned.

The propellant for the rapidly rising stock market level of the last few years has been a significant expansion of the price earning multiple. At the beginning of 2012 the multiple on the S&P500 was 13 and today it stands around 23 – having briefly touched 26 at the end of January this year. (Source: Thomson Reuters Datastream). In other words, over the last six years the market index has risen at close to twice the rate of underlying earnings.

This is a finite trend. Either corporate profits must now massively leap to justify the lofty multiple or the multiple sinks (and along with it the stock market) because no such ‘’leaping’’ occurs. We are sceptical of the former.

The stock market has also been supported by leverage. Margin debt relative to disposable personal income recently exceeded all previous peaks.

US: Margin Debt to Disposable Personal Income % 

(NYSE member firm margin data)

Source: Thomson Reuters Datastream

 

The technology bubble (and bust) in 1999 and 2000 is apparent from the chart as is the next market bubble which culminated in a peak leverage ratio (for that time) in mid-2007. The ratio hit 4.0 at the end of November 2017 but sadly we cannot update further as the New York Stock Exchange in its wisdom (!) has ceased to publish the data.

We do, however, have access to broader margin data published by the Financial Industry Regulatory Authority (FINRA) and it indicates that margin debt outstanding grew by 6% between November and January before falling slightly in February. Relative to the latest personal disposable income data available ( January) the debit balances in customer margin accounts (FINRA data) amounted to 4.5% of disposable personal income.

Leverage comes and leverage goes and when it does the latter it can lead to a scary market environment. Given the current market volatility it would take a brave person to forecast that we will not see a re-run of the peaks and troughs of the last twenty years.

Inflation is considered to be a major threat to the market and it is undeniable that it is creeping up in many parts of the world – including the US. Of the three key inflation components: services, durables and non-durables, the latter two are the most volatile but by far the more important of the two in the US is non-durables (it makes up roughly 30% of the index). The main constituents of non-durables are food, clothing and oil and gas.

A useful exercise is to plot the movement in the price of oil relative to the rate of inflation. It generates a remarkably strong correlation (see below).

US: Oil Prices and the Rate of Inflation  

(CPI – all urban sample)

Source: Thomson Reuters Datastream

 

In February 2016 the price of oil was precisely half its current level. The consumer price index (CPI) was resting around 1% (year-on-year) but has now doubled to 2%. Coincidence? We think not. It is the volatile elements of the CPI that push it about. Services may represent the lion’s share (60%) but the month to month movements are quite small. Not so with fuel (or food).

 

Management of the global oil market is improving but supply disturbance risks remain. We do not expect any major movement up or down, but then, we never do. Merely remaining around current levels will keep inflation firm whilst the non-volatile but larger component (services) maintains its very gradual and steady upward trend of around 2-3% year-on-year.

 

All information as at April 2018, unless stated otherwise

 

For professional investors only

 

Pyrford International is an independent investment boutique operating as part of BMO Global Asset Management.

 

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