Profit margins may continue to defy the skeptics and remain elevated. The primary drivers of robust corporate profit margins remain largely intact, including limited wage pressure, corporate efficiency, and low input costs, and support our view that earnings growth may be poised to accelerate through year-end and into 2016. Despite a lack of revenue growth, the operating margin for the S&P 500 remains near multi-decade highs; we expect corporate America to continue to defy the skeptics and potentially generate strong profit margins over the next several quarters and likely beyond.
The S&P 500’s operating margin remains near multi-decade highs despite several challenges. The business cycle is now more than six years old, a bit on the long side relative to history, which has led some to predict profit margin contraction. The economy has produced several years of steady job growth and the unemployment rate (5.1% in September 2015) is low, which would normally bring some upward pressure on wages and hurt margins. To an extent, margins are mean reverting, so they tend to head back to their long-term average after periods of strength such as we have experienced. Interest rates have bottomed, perhaps suggesting that borrowing costs may be poised to move higher. Yet, despite all of these reasonable arguments for margins to contract, the S&P 500’s operating margin remains near multi-decade highs. We see little reason to expect much, if any, margin contraction for at least the next several quarters. We expect strong profitability to support earnings growth acceleration in late 2015 and early 2016 and provide a favorable backdrop for the stock market. The primary drivers of robust corporate profit margins remain largely intact, supporting our view that earnings growth may be poised to accelerate through year-end and into 2016.
The market continues to expect that global gross domestic product (GDP) growth will accelerate in 2015 (3.0%), 2016 (3.4%), and 2017 (3.4%) from 2014’s 2.0% pace, aided by lower oil prices and stimulus from two of the three leading central banks in the world. The prospect for another year of decelerating growth in emerging markets remains a concern for some investors, who may stillbe waiting (in vain) for China to post 10 – 12% growth rates as it consistently did during the early to mid-2000s. The likelihood of rate hikes in the U.S. in late 2015 and the U.K. in early 2016 is also a potential growth headwind. Still, much stimulus remains in the system, and more is likely from the Bank of Japan (BOJ) and the European Central Bank (ECB), which may help bolster growth prospects in two key areas of the globe. Although China is unlikely to embark on quantitative easing (QE), Chinese authorities have recently enacted a series of targeted fiscal, monetary, and administrative actions aimed at stabilizing China’s economy in 2015 and beyond; more such actions may follow, but fears of a hard landing in China persist.
The Institute for Supply Management (ISM) released its Non-Manufacturing Report on Business for September 2015 on Monday, October 5, 2015, as this Weekly Economic Commentary was prepared for publication. It showed that the service sector remains robust, with the non-manufacturing ISM hitting 56.9, which over time, is consistent with real gross domestic product (GDP) of 3.5%. However, the report, as usual, was largely ignored by market participants, even though non-manufacturing activity (mainly the service sector) represents 70% of the U.S. economy. Financial markets, however, correctly focus more closely on ISM’s Manufacturing Report on Business, as S&P earnings — which over time, drive stock prices — are much more closely correlated to the manufacturing portion of the economy than to the service side. But for those concerned about a U.S. recession, the recent data on both the non-manufacturing and manufacturing ISMs are comforting. As noted above, the non-manufacturing ISM readings of 56.7 in September and 57.3 so far in 2015 indicate fairly robust economic activity continues in 70% of the U.S. economy. The manufacturing ISM data, however, are more concerning. Released last week, the manufacturing ISM for September 2015 came in at 50.2, below the consensus of economists as polled by Bloomberg News (50.6) and the August 2015 readingof 51.1. In fact, the September 2015 reading on the ISM was the lowest since May 2013, and indicates that the manufacturing economy, which accounts for just 30% of the U.S. economy.