Why have investors added risk to their portfolios in recent months?
This makes sense when looking at the broad economic backdrop. It is good news that business surveys suggest the global economy is expanding about 3.25 percent a year, the fastest since early 2015. The lagged effects of the mega Chinese stimulus last year, plus the welcome revival of more parts of the European economy, are clearly being seen.
However, it is important to analyze the drivers of company profits in more detail than simply assuming a straight correlation or relationship between real GDP figures and top line sales, let alone the drivers of company margins.
A few sector examples would be the importance of movements in commodity prices in the case of oil producers or mining companies, or the shape of the yield curve affecting the profitability of the financial sector.
One proxy for pricing power is the performance of core inflation, stripping out the volatile effects of food and energy prices. Despite steadily lower unemployment, underlying inflation is restrained across most advanced and many emerging economies.
A variety of cyclical but especially structural drivers appear to be at work, including the global amount of spare capacity, changes to the shape of the Phillips curve due to labor market developments, new technology bearing down on prices, or more anchoring of inflation expectations in relation to wage demands since the financial crisis.
Even though we are upbeat on global growth, our analysis suggests that core inflation is unlikely to surge away. This has important implications: for example, central banks will remain cautious in their policy tightening into 2018, while it will take more time for indebted households and businesses to work through their liabilities in a low inflation world.
This situation also matters for company profits. The strong S&P 500 earnings season in the spring was very welcome, although we saw the importance of overseas demand and the high-flying tech sector.
Now we assess the progress of the second quarter – currently quite upbeat. These figures can be cross-checked with components from the United States’ GDP report. By the first quarter, non-financial corporate profit margins had declined to 12.5 percent from a peak of 15.5 percent in 2014. A mixture of weak productivity, slowly rising wages and restrained inflation all played their part.
Into the summer, investors will want to see if these trends continue. Perhaps a smaller corporate tax bill and more business deregulation from US President Donald Trump might help, but then perhaps a lower US dollar and higher import costs plus inexorably rising borrowing costs due to Fed tightening will work the other way.
In our opinion, watching core inflation is as important as watching headline economic growth for future signals of how much risk investors should take on board.
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