Hugh Selby-Smith, co-CIO at Talaria, said that established relationships between interest rates, leading economic indicators, and corporate earnings all point towards falling profitability into the second half of 2023.
“After a pandemic low in early 2020, profitability recovered sharply to reach record highs, and, following the latest earnings season in the US, some analysts are forecasting further expansion,” Mr Selby-Smith said.
“In our view, these analysts are living in a parallel universe because there is a swathe of data highlighting the risk to corporate profitability. For example, corporate profits as a percentage of GDP are at a 75-year high.”
He added that this has coincided with depressed labour costs, but wage growth is on an uptick due to there being twice as many job openings as unemployed persons, according to the US Bureau of Labour Statistics.
“Furthermore, interest costs and tax are impacting on profitability,” Mr Selby-Smith said.
“It is an understatement to say it is difficult to see how future profitability is going to experience tailwinds. We know that interest rates are up, and even if the recently passed Inflation Reduction Act did no more than try to limit corporate tax avoidance through a 15 per cent minimum, it does suggest the direction of tax travel is no longer south.
“It is perhaps telling that in the latest earnings season in the US, many companies are not offering forward guidance — only about 20 per cent offered guidance compared to a more usual 70 per cent or so. It is notable that these companies do not feel confident about making these sorts of forecasts in the current environment. At the same time, the market has more actively punished those offering poor guidance than those withdrawing guidance.”
Mr Selby-Smith said that the “elevated margins and rich valuations” experienced since the global financial crisis has lulled many investors into a false sense of security.
“But deeper analysis is important. Breaking returns further down into changes in sales, EBIT margins, tax, interest, and valuation — it is striking that operating margin expansion accounted for one-third of that return,” he said.
“If nothing else, given the record level, it throws the responsibility on the optimists to explain why the future should be the same, or indeed why there should be a positive contribution at all.
“The third most important component was valuation, which accounted for one-fifth of the return. Again, we would be interested to hear the case for a similar, or even for a lower but positive contribution over the next decade.”
Talaria has forecast a 10-year prospective return for the S&P 500, with the most optimistic scenario being a prospective long-run average annual nominal return of 6.1 per cent, but Mr Selby-Smith said the underlying assumptions required an extremely optimistic viewpoint.
“What none of the models show is that the long-run return would almost certainly be bumpy and, in the downside case, the market might well rebase first, falling to reflect a combination of earnings’ downgrades and valuation contraction,” Mr Selby-Smith said.
“On the plus side, any decline improves the outlook for returns, and should markets rebase this should provide a materially better starting point for investors to add to the risk.”
