Equity Strategy: Three key drivers of to date resilient corporate profitability to turn weaker

Speaker: Mislav Matejka, CFA - Head of Global Equity Strategy

Bulls are to a good extent basing their constructive market call on the premise that corporate profits are set to accelerate, supported by the bottoming out in activity indicators that is now in progress. However, the earnings reality might turn out to be the opposite as we move through the year. In aggregate, corporate profit margins are elevated in a historical context, and appear to be peaking out. The historical pattern where profit margins always start to move lower ahead of the next economic downturn is clear. We see three sources of downside to profit margins from here: 1) Many corporates benefitted from the unique feature of this cycle: as interest rates increased 300bp+, the net interest expense came down. That could be explained by companies locking in low cost of financing through extending the duration of their debt, and also through many corporates seeing an improving return on their cash balances. This development is set to normalize. Separately, the basket of stocks with high refinancing needs is losing 20% vs SXXP over a year ago - JPDEHFCL, and our basket of cash rich companies is ahead by 14% - JPDEHFCW. We think this outperformance will continue through 1H. 2) Topline was exceptionally strong post COVID for many corporates, and pricing power was high. As nominal GDP growth rates fade, margins could weaken. 3) If the economy slows, partly because the supports that it enjoyed last year do not repeat, such as fiscal stimulus, ULCs could pick up. Profit margin proxy, corporate deflator minus ULCs, could turn into more of a headwind. Putting the above three together, one might end up with a disappointing profits outcome even without seeing an outright recession, and we note that 2024 EPS projections keep coming down in key regions. It is interesting to note that for S&P500 all the profit growth in the past few quarters was due to Magnificent 7, and this is one of the reasons why we remain OW Growth vs Value.  Ex these stocks, EPS growth for the remaining S&P500 constituents is outright negative.

This podcast was recorded on 26 February 2024.

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