With a boost from tech companies, the S&P 500’s profit margins have reached multiyear highs. Can the trend continue?
Four of the most dangerous words in investing are “This time is different.” However, when it comes to the current sustainability of corporate profit margins vs. past cycles, this time may truly be different. The reason? The dominance of high-margin technology companies.
History suggests that after a seven year bull market, which has taken the major stock indexes to all-time highs, subsequent years would inevitably bring lower returns. But when the Global Investment Committee recently published its strategic seven-year forecasts, it only trimmed annualized U.S. equity returns modestly—from 5.3% to 4.9%—in part because it does not expect a significant contraction to profit margins.
This view contrasts with several prominent market forecasters who predict profit margins will revert to lower historical averages, an outcome that would be more reminiscent of prior cycles. But when factoring in tech companies with high profit margins it’s possible a different trend emerges.
On a number of metrics, corporate profit margins have reached multiyear highs and exceeded prior-cycle levels. For example, the net profit margin for the S&P 500 is now 10.3%, versus the prior-cycle high of 9.9%. Additionally, this cycle stands out for its divergence between the lackluster economic growth—average real GDP is 1.3% since 2009—and the stock market, which, thanks in part to unprecedented monetary stimulus, is up nearly fourfold since its 2009 low.
Are the S&P 500's High Profit Margins Sustainable?
One way to represent this juxtaposition is by noting that labor-compensation’s share of GDP fell to 53% by 2016 from a recent high of 58% in 2001 while corporate earnings’ share of GDP rose to 11% from 2001 levels of 7%—illustrating the vast outperformance of financial assets versus the real income gains of the populace.
While companies throughout various industries cut costs and managed to boost their margins during the past seven years, technology companies in particular, with their inherently high profit margins, were a significant contributor to overall margin growth. Indeed, the technology sector accounted for 45% of the expansion of the S&P 500’s overall margin.
While tech has worked well this year, Morgan Stanley & Co. Chief Equity Strategist Mike Wilson continues to overweight the sector given its earnings momentum, benefits from late-cycle capital spending and the potential for a tax repatriation holiday that would disproportionately benefit tech, given its outsized share of cash held overseas.
In our view, today’s margin levels will not revert to previous cycle lows given the S&P 500’s current makeup. Four of the five largest companies in the index are technology companies that were not in the top 10 in 1990. They have margins in excess of 20%, which raises the index’s overall margin level.
Also, these companies carry little or no inventory on their balance sheets and are inherently less capital-intensive than many of the more cyclical top holdings of the market index in past cycles. As such, they may be able to maintain margins better in an economic downturn, as they won’t have to write off idle inventory.
Many of these high-margin tech businesses benefit from secular growth in trends such as online advertising, social media, cloud adoption and e-commerce. Here, the barriers to entry and benefits from scale make it harder for new competitors to disrupt the market leaders and their profit margins.
One potential risk, however, is that the government starts to scrutinize this monopoly-like behavior. While we don’t see this as a base-case scenario, it is possible that the unconventional administration in the White House, with its populist roots, may take a harder look at these dynamics. Should these tech giants experience margin pressure, it raises downside risk to our more sanguine outlook for overall margins and returns.
Note: This article first appeared in the June 2017 edition of “On the Markets,” a publication of the Global Investment Committee, which is available on request. For more information, talk with your Morgan Stanley Financial Advisor, or find one using the locator below.