Alongside the inevitabilities of long-term interest rates
picking up and inflation firming, one of the most obvious things that was going
to happen over the course of this year was a narrowing of profit margins. Indeed, with third-quarter earnings advancing
at around twice the pace of a sales gain of just 5.3%, profits as a share of
revenue for companies in the S&P 500 look to now stand at 10.1%. That is
the widest profit margin in the 22 years of data S&P Dow Jones Indices has
on hand. A longer-dated measure—after-tax corporate profits as a share of gross
domestic product—last year reached its highest level since 1929.
A big reason margins have continued to widen is wage
gains—or more aptly, a lack of them. Average hourly earnings continued to grow
weakly in October, and were up just 2% from their year-earlier level, according
to the Labor Department. That is even though companies have been hiring over
the past year at a faster clip than economists expected, with the unemployment
rate falling to 5.8% last month from 7.2% a year earlier.
Another reason margins are so high is that companies have
been slow to spend. Commerce Department figures available through the first
quarter show investing in new equipment relative to private industry output was
low compared with prevailing levels before the recession. While there has
probably been some pickup since then, companies remain reluctant to spend on
longer-term projects without an immediate payoff.
The argument that margins must narrow goes something like
this: Demand has reached the point where companies can’t meet it without hiring
more workers, and the job market has reached a point where workers are in a
stronger position to bargain for higher wages. So companies’ labor costs are
heading up. And if they’re smart, they’ll spend more on labor-saving equipment
that will help them boost productivity, and mitigate future labor cost
increases.
Today’s wide profit margins probably owe a lot to changes in
the investing climate. Those other two mysteries—persistently low interest
rates and inflation—have led to profound changes in what many investors look to
stocks for.
With bonds offering little in the way of yields, for
example, income-focused investors have turned increasingly to stocks. They are
more apt to reward managers who generate and return cash to shareholders over
managers who are looking to reinvest and grow. Moreover, low inflation lowers
the risk for companies of not investing heavily in growth and seeing rising
prices overwhelm the spending power for future revenue.
To that, add still-painful memories of the financial crisis
and the growing clout of activist funds. So it’s easy to see why companies are
reluctant to take chances that might damage margins and anger investors. That
is the case even if those riskier moves have potentially big payoffs over the
longer haul.
Eventually, things will change. Companies will no longer be
able to keep labor costs at bay, interest rates and inflation will rise, and
investors’ focus will swing back toward growth. But as the persistence of wide
profit margins has shown, eventually can be a long time coming.
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