Analysts are too optimistic about margins and U.S. stocks are more vulnerable to shortfalls in earnings than other countries, said Mathieu L’Hoir at AXA Investment Managers, who helps oversee $730 billion. Should the Fed succeed in encouraging hiring, corporate profit margins would likely suffer from higher wage costs, he said.
“Betting on higher profit margins from here is betting the Fed will fail to boost employment,” L’Hoir, investment strategist at Paris-based AXA, said in a phone interview. “Profit margins are currently the risk and weak spot for earnings next year and therefore for U.S. stocks.”
Annual earnings have fallen 10 of the last 11 times that margins shrank, according to Bloomberg data since 1973. Profits declined an average of 11% in those years, compared with a 16% increase in years of expanding margins.
Mario Gabelli, the founder of Gamco Investors Inc., said investors betting interest rates are likely to remain low in the next 18 months due to a weak labor market may be disappointed. Yellen may find the economy is strong enough to lift borrowing costs even if employment remains below the Fed’s target, he said.
“Do not assume that Yellen won’t pull the trigger and raise rates without telegraphing that she is going to raise rates,” Gabelli, who helps manage $43 billion, said in a phone interview on Nov. 26.
Analysts say profitability has room to improve. Margins will climb to 10.5% in 2014 and 11% in 2015, more than 11,000 estimates compiled by Bloomberg show. The previous record was 9.8% in July 2007. At the same time, S&P 500 revenue growth is forecast to reach 4.4% in 2015, according to the average of analyst estimates.
“American companies have been able to resize their balance sheets, to slim down their costs, and that has proven fairly favorable when we started to see some strong top-line growth,” Ilario Di Bon, who helps oversee $7.6 billion as head of equities at Alliance Trust in London, said in a phone interview. “Yellen has said, ‘let’s make sure that policy remains accommodative for a longer rather than shorter period of time to give the real economy time to adjust.’ I would expect 2014 to be favorable to equities.”
American businesses are positioned to increase earnings even if profitability doesn’t expand because sales should pick up, according to Walter Todd, chief investment officer at Greenwood Capital Associates LLC in Greenwood, South Carolina.
“If margins fell a little or even if they just stayed the same but revenues picked up, you’re way better off,” Todd, who helps manage $950 million, said in a Nov. 27 phone interview. “Those revenues can manage any margin deterioration, that’s a good scenario.”