Are yesterday's tailwinds tomorrow's headwinds?

October 26, 2021 06:00
Photo: Reuters

While a decade of economic stagnation followed the global financial crisis, it was an extraordinary time for corporate profits and shareholder returns. However, the policy response to the pandemic put an end to an era of stagnation and fostered a remarkably fast recovery in global profit margins. Economic growth is now fading much faster than expected while the magnitude and duration of supply-chain disruptions is driving costs higher for both producers and consumers. While bottlenecks may prove temporary, conditions have clearly worsened. This raises the question of whether risk assets prices are fully reflecting the negative impact on profits from a potential steep decline in revenues and higher input costs.

Years of stagnation

Following the GFC, financial repression (central bank policies that hold interest rates below the rate of inflation) made capital cheap and abundant. Weak growth prospects signaled to producers that they should allocate resources elsewhere instead of stimulating investment. Borrowed funds were used to buy back stock. New technology allowed enterprise to digitize and optimize operations from the back-office to the front-office. Labor was outsourced. Supply chains were stretched in search of the greatest possible cost savings. Payables for goods owed were both extended and financed to enhance working capital.

That created a feedback loop. Anemic growth pushed capital away from investment in property, plant, equipment, labor and the like. To policymakers’ dismay, the forces of stagnation were only bolstered by a falling cost of capital. Net income grew because operating cash flows were substituted for financed cash flows and underinvestment. The result was a decade of weak economic growth and low inflation but massive return on capital, as shown in exhibit 1.

Everything’s now in reverse

While these negative supply shocks have been labeled as transitory by many, the reality is that they do affect the real economy and corporate profits in two simple but distinct ways: They weigh on growth and push prices higher. Shocks such as these limit the number of goods a company can sell and cut revenues. Whenever the supply and demand balance is upset, prices adjust. Today’s disruptions are adding cost pressures across numerous inputs, including labor, materials, and energy, and pressure on any of these inputs can negatively impact net income.

Input costs usually rise during economic recoveries but rarely pose a problem for margins. That’s because units sold and pricing power typically more than make up for the higher costs. That’s been the case in this recovery, as well. But what’s changed?

In recessions, market forces typically demand that companies de-lever their balance sheets. But the opposite happened this go-round. However, bondholders and lenders expect their coupons to be paid and their principal returned regardless of whether a company’s shelves are empty or if its energy costs have tripled. As growth slows, it could force weaker companies to cut prices to remain competitive. The combination of softer sales and unbudgeted expenses for less-competitive enterprises would be an ugly outcome. Today, credit spreads are two standard deviations tight from their historical average as the thirst for income has seemingly overwhelmed credit risk considerations. As stimulus fades and economic growth slows, we believe companies with weak balance sheets and undifferentiated products will be the ones to avoid.

For many companies, margins are at all-time highs. In a high-earnings-multiple environment like today’s, it’s important for investors to remain focused on the price paid. This includes the multiple, as well as the earnings estimate underlying it, as a valuation is only as good as the underlying
fundamental assumptions.

‘70s redux?

As economic growth reverts to levels closer to its prepandemic rate, investors should be concerned about the profit tailwinds of the post-GFC cycle shifting into headwinds. I’m not an economist, and I’m not suggesting the next few years will look like the stagflation of the 1970s, but I do care about how externalities impact income statements. My concern now is that the combination of a return to trend growth, excessive corporate debt and rising costs — not just from bottlenecks, but also from other, new factors — suggests we may experience a return-on-capital backdrop that isn’t as rosy as expected.

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Global Investment Strategist, MFS Investment Management