20 March 2019
Most of the tailwinds behind high profit have begun to falter and margins have narrowed for most of the S&P 500 firms. Photo: Internet
Most of the tailwinds behind high profit have begun to falter and margins have narrowed for most of the S&P 500 firms. Photo: Internet

It’s getting late — in the business cycle

I remain disenchanted with stocks and I need to see improvement in a number of key metrics before changing my view.

1. Improved pricing power for US-based multinational companies

2. Better consumer spending on goods and services

3. Rising capital expenditures, especially in information technology

4. Moderating labor and health care costs

I’m focused on the behavior of the private sector and its ability to generate free cash flows.

During this business cycle, which began in July 2009, the United States and many developed markets experienced record-high profit margins, best-ever free cash flows relative to the size of the overall economy and high returns on equity.

This surprised many cautious investors given that both the global and US growth rates had fallen below trend.

The reasons for the high profit generation, which were complex, included gains in manufacturing sector efficiency, the productive use of technology, rapid asset turnover, capital-light strategies, employment of global labor, use of operating leverage instead of financial leverage and low energy costs.

During the past three quarters, most of these tailwinds for risk markets have begun to falter.

Margins have narrowed not just in the materials and mining sectors but throughout much of the S&P 500, countering well-established trends that dated back to 2009.

Selling, general and administrative (SG&A) expenses have been rising as a percentage of revenues.

Financial leverage is replacing operating leverage and both returns on equity and margins have continued to weaken into mid-year.

All of these measures feed into a very important metric for me — the share of US gross domestic product going to the owners of capital.

When the share of the economy going to the owners as profits begins to subside, a direct casualty is capital expenditure and durable goods spending.

Both are now weakening.

Big-ticket expenditures such as purchases of machine tools by manufacturing firms and information technology spending are a key to future growth of both jobs and profits and tend to perpetuate the cycle.

These large expenditures by businesses have been weakening and the trend is downward.

The US consumer is doing better.

Spending is increasing but consumers have not spent the extra income afforded by the earlier oil price decline.

And now, worryingly, energy prices are rebounding. The US dollar has been weak during much of this cycle but now, because of interest rate differentials and a flight to safety, the dollar has been heading back up.

The strong company fundamentals that were the signature of this longer than usual cycle have weakened in almost all categories.

Overall, I am biased toward being underweight equities.

Within equities, I would overweight US shares relative to those of the United Kingdom, the eurozone and Japan.

Some emerging markets look attractive, particularly Latin America and Eastern Europe but selectivity is very important, as always.

In fixed income, I prefer high-yield for certain investors because fundamentals in the US remain solid, with the odds favoring the US avoiding recession near term, in my view.

History tells us a weakening of the profit cycle can herald recession.

Usually, a profits recession comes as rising interest rates hijack consumer and business spending.

US recession risks are rising but the risk of rates rising seems remote now.

Rather than a recession unfolding soon, I see a continuing plague of profit disappointments but no economic collapse. A kind of investor’s limbo, if you will.

I hope the five metrics above reverse but unless they do, late-cycle flags should be a caution to investors.

– Contact us at [email protected]


The author is Chief Investment Strategist at Massachusetts Financial Services

EJI Weekly Newsletter

Please click here to unsubscribe