US debt and corporate margins
0Whilst Euroland’s debt woes have captured most of the headlines and commentary, the US debt position remains a major challenge.
Yet while attention is now focused on whether or not the Supercommittee will come up with its minimum targeted $1.2 trillion (or a bit more), in practice, this is another example of how great dramas that are newsworthy can, at the time they are transpiring, be mistaken for matters of great importance.
Whether or not the Supercommittee reduces the projected budget deficit by a couple of trillion over the next 10 years is not material to us because the private and public sector debt funding gaps are many times that.
For example, we are much more interested in how the supposed €29 trillion of European bank assets (or,
if you prefer, the €11 trillion in risk weighted assets) that are being supported by €1 trillion in capital will be deleveraged.
However, how policy makers approach dealing with such deleveraging issues is very important to us, so we view the Supercommittee’s handling of this issue as another straw in the wind and from a market perspective the US outlook is important, not least because the US profit share of GDP and corporate margins are at all-time highs.
Some commentators expect corporate margins to shrink back, exhibiting some form of mean reversion, yet the most important driver of margins has been labour losing pricing power and that does not look to be at risk for now. Historically, US margins have peaked when wage growth was 3.5% (vs 2% currently) or when there was full employment (c7% unemployment rate).
Margins have three important structural drivers: improved productivity (GDP is back to previous peak in the US but with 6.5m fewer workers), lower depreciation charges (outsourcing of capital intensive businesses) and interest charges at a 50-year low. The US equity market’s Return on Equity (RoE) is only slightly extended and can be supported by an increase in leverage (boosting earnings by c10%).
Taking a cautious but realistic view, there may well be zero EPS growth for the US in 2012 (which
would mean $96 of eps for the S&P500 vs $107 consensus). In Europe, we may well see minus 2% EPS growth in 2012, based on economic growth, margins, and even assuming a 10% weaker euro, and Euroland earnings are most vulnerable based on margins (relative to their norm), sales growth (relative to 2011), wage growth and the exchange rate. Global emerging markets (GEM) and Japan are the least vulnerable markets in terms of geographies.
Turning to sectors, with a focus on margins (vs norm), revenue growth (vs norm), pricing power score
(using CPI/PPI) and earnings revisions, the most vulnerable European sectors are autos, construction, media and beverages.
The least vulnerable sectors in Europe look to be utilities, energy, software and chemicals.
If we combine this with valuations, energy, drugs and mining look the most attractive with media, beverages, construction and healthcare equipment being the least attractive.
James Bevan is chief investment officer of CCLA, specialist fund manager for charities and the public sector. CCLA launched The Public Sector Deposit Fund in 2011 to meet the needs of local authorities and other public sector organisations. You can follow James on twitter @jamesbevan_ccla
