Under pressure
Profit margins in the age of the great transformation
- The new capital markets regime of the great transformation is changing the outlook for profit margins
- After decades of tailwind, the drivers are now changing and margin growth will be dampened
- But this is precisely why margins will be even more important for stock-picking
Regime change with consequences
A report recently published by the ifo Institute of Economic Research under the title ‘Profit inflation and inflation winners’[1] examined whether prices are rising purely because companies are passing on their higher costs to customers, or whether companies are adding on a little more and boosting their profits. The report concluded that in most cases inflation is in fact the result of higher input prices. However, there are also sectors such as agriculture, construction and some areas of retail that have used the general trend of rising prices to significantly expand their profits. Pricing power is an important factor here. Only businesses that are reasonably confident that customers will continue to buy their products – even at higher prices – can afford to increase their margins (put simply, the difference between the price at which the product/service is sold and its cost).
In this paper, we take a closer look at profit margins and how they are changing. We explain why they have consistently grown in past decades and set out our expectations for the future. In the great transformation – a period marked by higher inflation, stronger growth, higher interest rates and, above all, greater volatility[2] – the old, familiar drivers are changing. Where are profit margins heading in the coming years, once the inflation overshoot is history?
Profit margins have many drivers
Looking back, we can see that not only have the absolute profits of US companies[3] increased substantially over the past two decades, but on average, profit margins were significantly higher in the past 20 years than in the preceding three decades.
In the first decade of the new millennium, globalisation was a key driver of margin growth in two ways. Firstly, the offshoring of production led to enormous efficiency gains, primarily due to lower manufacturing and labour costs. In the period between 1999 and the financial crisis of 2008, the non-domestic share of gross profits earned by the US companies studied increased from around 20 per cent to more than 40 per cent. But labour costs at home were also lower. Wages decreased as a proportion of total costs – particularly in those sectors where goods are easily tradable and were thus exposed to greater international competition.
The growing importance of information and communication technologies also helped to push margins up, partly because they boosted productivity in some sectors of the economy and partly because the greater focus on business models from the tech sector reduced the capital intensity of the economy as a whole. The relative cost of capital (i.e. capital equipment) thus declined further in the first decade of the 2000s. Prior to that, the situation had been very different. The 1990s was a period of significant investment, as evidenced by the high depreciation and amortisation expense in the decade that followed, which depressed margins.
Many of these drivers continued to have an impact after the financial crisis of 2009, although not always to the same extent. Labour costs decreased, for example. The main factor now was falling interest rates. Although corporate debt rose substantially over the same period, this was more than offset by the structurally low level of interest rates.
During the pandemic, the tax breaks and subsidies introduced to support the economy pushed margins even higher. As liquidity reserves increased sharply in conjunction with the rise in corporate debt, and interest rates remained persistently low, this combination of factors did not initially put any pressure on margins either.
Higher margins, changing drivers
Breakdown of the change in profit margin of US companies outside the financial sector
Market consolidation, especially in the tech sector, has also had a positive effect on margin growth over recent decades. A glance at the broad US share indices reveals that margin growth was almost exclusively confined to the technology, media and telecommunications sectors. One reason for this, in addition to the scalability of digital products and services, may be the increasing monopoly power of some tech corporations.
Tailwind becomes headwind
So various factors have contributed to the tailwind for profit margins in recent decades. But in this decade of the great transformation, many of these drivers will reverse course (or are already doing so). As a result, profit margins for US businesses are likely to be structurally lower than they have been used to. There are many reasons for this:
- The positive effect of globalisation on margins had already begun to decline even in the years before the pandemic. Now, in the great transformation, the focus is on the restructuring of strategically important supply chains and the return of production to, or closer to, the home market (re-, near- and friendshoring). However, the increased resilience in supply chains (in some cases government-mandated) inevitably leads to more inefficiencies and thus higher costs, which companies will presumably not be able to pass on in full to the end customer.
- The demand for domestic labour fuelled by reshoring has bumped up against a structural shortage of supply. This means higher costs for labour. Although this may be offset in the medium to long term through increased productivity growth, for example where investment is made in digitalisation and automation, history tells us that the initial effect on profit margins will be strongly negative. Generally speaking, margins have been lower whenever labour costs have accounted for a larger share of gross value added.
- We also anticipate a shift in the price of capital assets. While intangible assets (such as software and rights of use) have accounted for the majority of capital expenditure in recent decades, the process of reshoring has meant a greater focus on physical assets such as factories and machines. Strong brands with corresponding pricing power are less of a factor here, which is another reason for lower average margin growth.
- The picture is similar for the cost of capital. We expect interest rates to be structurally higher than in previous decades. Part of this change has already materialised. Because liquidity reserves are still high and many companies still have access to cheap borrowing, the effect of the increase in interest rates will not be apparent straight away. However, the need for greater capital spending (see above) will also mean higher net interest cost, which will also put downward pressure on margins.
- Nor can companies look to taxation as a source of relief. The practice of countries seeking to undercut one another with ever-reducing rates of corporation tax has come to an end. However, we are unlikely to see excessive tax increases in the US at least, given the political majorities there. The effect on margins is thus only slightly dampening.
- The supporting factor of monopoly power is also likely to weaken only slightly. Generally speaking, more competition means less leeway on margins. But regulation is unlikely to be too onerous in the US, so the negative impact on margin growth will only be slight.
Another driver that will reverse course as a result of the great transformation is inflation. The past few decades have been a period of persistently low inflation. This could explain not only the unusually strong pricing power of companies but also the low wage demands, due in part to a phenomenon known as rational inattention. When overall inflation is low, higher price mark-ups by companies are less noticeable – little attention is paid to the question of how the relatively low prices are made up.
However, an environment with the structurally higher inflation that we expect in the coming years could change this. With higher mark-ups, more attention will be paid to the question of why the prices are rising – see for example the debate surrounding the excess profits tax. This makes it harder for companies to achieve higher margins. An analysis of various inflation regimes provides some evidence for this explanation: in the past, structurally higher inflation has gone hand in hand with lower profit margins.
Revenue growth is the dominant driver of profit again
Contributors to profit growth
This trend also has implications for the capital markets. Over the past two decades, profit growth has been made up of growth in revenues and growth in margins in roughly equal measure. This was not the case in the preceding decades, and we expect the great transformation to renormalise the situation. Revenue growth will become the dominant driver again. And, in contrast to previous decades, there are now more companies capable of increasing their revenue. Growth is no longer a scarce factor. However, as we have shown, profit margins will come under structural pressure. We expect investors to concentrate on consistent and high profit margins in future, largely independently of sectors and regions. The focus will be on companies with relatively low levels of debt and thus a lower interest burden. Companies that are already highly automated and are therefore less affected by rising labour costs will also be of interest. Earlier beneficiaries of globalisation, in contrast, are likely to have a tougher time.
- 1 Joachim Ragnitz (ifo Institute of Economic Research, Dresden branch) – Gewinninflation und Inflationsgewinner, updated 7 December 2022
- 2 See our white paper The end of stability: investing in a more volatile world, published in November 2022.
- 3 Due to the better availability of data, especially over a long-term view (source: National Product and Income Accounts of the U.S. Bureau of Economic Activity ), this paper focuses on US companies. Some of the drivers discussed (such as globalisation) also apply to European companies while others (such as the strong focus on tech companies) are not directly applicable.