A businessman is about to arrive at the White House with his crew of business people and a very business-like attitude.
While Trump’s top appointees have less government experience than most administrations since the 1960s, they have by far the most business experience, [Ray] Dalio [whose Westport, Connecticut-based firm is the hedge fund industry’s largest money manager] said. They are “bold and hell-bent on playing hardball” to effect major changes in economics and foreign policy, and their leader “doesn’t mind getting banged around or banging others around.”
It is thus appropriate to analyse this mega cap stock USA Inc. and try to realistically assess its outlook based on objective fundamentals. Can this truly wholesale management change, this potentially “novel” way to run the country, herald a new era of growth and prosperity for what is still the main engine of the world?
Let’s begin by looking at valuation parameters and then see if a sensible and credible story can fit in. The chart below plots the so-called Buffet Indicator which is akin to a Price-to-Sales ratio for the U.S. economy (market value of U.S. equities divided by GDP – blue line) and a proxy for corporate profit margins.
Here’s another proxy for corporate profit margins from the national accounts (for a discussion on secular margins trends, see CETERIS NON PARIBUS) :
USA Inc.’s Price/Sales ratio is at a historical high (ex the internet bubble) but this extreme valuation is accompanied by profit margins that are also historically high. A dollar of high margin sales is clearly worth more than a dollar of low margin sales.
USA Inc.’s P/E proxy (market value of U.S. equities divided by Corporate Profits – red line below) is at the high end of its 60-year range of 10 –15 times (with periods below 10 when inflation is high) but nowhere near the internet bubble years’ valuation. By this measure, USA Inc. is expensive but not bubbly like in 1998-2000.
Nonetheless, we are clearly in “buy high” territory. The main question is the sustainability of this precarious state which leaves little room for unfulfilled expectations from poor fundamentals or bad execution. Investors’ confidence on USA Inc.’s growth and profit potential needs to be constantly nurtured from here on out.
Realistically, USA Inc.’s revenue outlook remains constrained by the rather immutable demographic trends of slow growth in the available workforce and weak productivity (output per worker). In truth, production and revenue growth is highly dependent on productivity going forward.
The aging process is accelerating which will likely exacerbate the difficulties: more and more workers will leave the company and the average age of the remaining employees will keep rising, extending the productivity challenge.
Unless USA Inc. welcomes young foreigners, it will need to invest heavily in automation to sustain productivity growth, something corporate America has not done enough in the last cycle.
USA Inc.’s real top line growth (real GDP) averaged 1.4% per annum since 2006, a big step down from +3.4% during the previous decade. About 40% of the slowdown is due to demographics and 60% from slower productivity growth. Demographics will likely shave another 0.3% per year during the next 8 years, requiring productivity growth to double just to bring real revenue growth to the current consensus level of 2.0% per year. Easier said than done for such a large and well diversified company that has been a pioneer in global sourcing and procurement.
Even with hard-ball managers, USA Inc.’s top line growth, in real terms, is thus more than likely to remain subdued for a while longer.
Higher inflation rates can boost nominal revenue growth but unless inflation on revenues neatly exceeds inflation on costs (e.g. inflation outgrows wages), the impact on profits is zero or negative.
Can profit margins keep rising?
- The secular decline in labor’s share of profits seems to have reached a low point in 2012. Most of the recent cyclical decline in margins has been concentrated in the energy complex but it remains to be seen if aggregate margins will recover along with energy profits. Other than for Reits, sector profit margins have not expanded in recent years in spite of very slow wage growth, a halving in energy prices and rock bottom financing costs.
The growing tightness in the labor market is pushing wage growth rates above inflation which can only squeeze operating margins if productivity growth fails to compensate.
Unit labor costs are currently rising at 3.0% YoY, pressuring margins since nominal GDP growth has averaged a weak 2.7% in 2016.
- Energy costs have declined spectacularly in the last 2 years but this tailwind has all but disappeared lately: YoY, prices are +7.7% for oil, +22.0% for natural gas, +1.0% for coal and +0.2% for electricity which usually trails coal and natural gas prices.
The pressures on USA Inc.’s operating profit margins are intensifying due to deeply fundamental trends: a slowing and aging labor force, a tightening labor market, weak productivity and rising energy costs. Investors have been quick to focus on the potential benefits of deregulation. Strangely, they are totally oblivious to the potential adverse impacts of this new management team’s other policies: openly anti-immigration, highly protectionist and prompt to fight corporate strategies aimed at “optimizing operations”, a convenient euphemism for increasing profit margins, something USA Inc. has been very good at during this cycle characterised by slow demand and low inflation.
This management’s policies could effectively deprive corporate America from the very tools which enabled it to keep growing earnings amid a difficult macro environment. It is doubtful that deregulation will be timely and potent enough to offset the fundamental pressures on margins during the next few years.
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Meanwhile, a lady is entering the last year of her mandate at the helm of the powerful Federal Reserve. The “footloose and collar-free” Trump has not shown much fondness for her:
I think she is very political and to a certain extent, I think she should be ashamed of herself.
Nor has he given her much hope for a second term:
She is not a Republican. When her time is up, I would most likely replace her because of the fact that I think it would be appropriate.
Some pundits speculated that Mrs. Yellen would quickly resign (“when the baby moves in, the dog moves out.”) but she rather wasted no time confirming that she will see the end of her term in February 2018.
Three extracts from her post-FOMC press conference of Dec. 14 reveal her true motivation (my emphasis):
- So let me say that our decision to raise rates is—should certainly be understood as a reflection of the confidence we have in the progress the economy has made and our judgment that that progress will continue. And the