2018 has been kind to corporate profit margins. In fact, the margin expansion we’ve seen so far in 2018 is unprecedented in a late cycle economic environment when wages are rising briskly, at least looking back over the last thirty years. What has been different this time around is that the corporate tax rate was lowered from 40% to 25%, allowing profits to expand even in the face of rising wage and variable cost pressures. So the question moving forward is, can companies maintain this level of profitability for another few years, or have we seen the best of it? Based on at least the few factors we highlight below, we think 2019 and beyond will look much different from 2018.
As we can see in the first chart below, there is a strong negative relationship between profit margins (blue line, left axis) and average hourly earnings (red line, right axis, inverted). When average hourly earnings rise, margins invariably fall with a two year lag time. Average hourly earnings have been rising in a strong trend (red line going down) since early 2017, but profitability was able to buck the consequent drop off due to tax reform. However, now that hourly earnings have so clearly broken out to the upside and are rising at the fastest pace since 2007, we have serious doubts about the ability of profit margins to not follow the path of least resistance, which is down.
And we further have reason to expect hourly earnings will continue to rise even more briskly in the year ahead, which of course will add duration and magnitude to the pressure on margins. As the next chart below demonstrates, small business hiring plans lead hourly earnings growth by 15 months. Hiring plans (blue line) remain near an all-time high and in a strongly rising trend. As such, hourly earnings growth (red line) has every reason to follow hiring plans higher for the next year or so.
But it doesn’t stop there. Profit margins also tend to closely follow the unemployment rate. As the unemployment rate falls (especially as it falls to very low levels at the end of an economic expansion), hourly earnings tend to rise, which puts pressure on margins. Here we overlay profit margins (blue line) on top of the unemployment rate with a two year lead (red line). In this chart it’s easy to see the disconnect between the drop off in the unemployment rate since 2016 and profit margins. Part of this is due to structural factors (historically low employment to population ratio, tax cut) and part of it due to cyclical factors (fiscal stimulus). However, with the unemployment rate now at a 50 year low and falling, our confidence is low that either structural or cyclical factors will prevent margins from reverting to their historical relationship with employment.
Finally, we’ll review one element central to the margin question that is unrelated to earnings and employment: import prices. As of now non-petrol import prices are set to rise on the back of tariffs on Chinese imports, and steel & aluminum imports from elsewhere. There is plenty of upside risk to import prices if trade talks with China fail to produce results acceptable to the US. Some of the cost of higher import prices are likely to be shared by corporations, which would pressure margins. As we can see below, there is a clear, although loose leading relationship between import prices and changes in profit margins. As import prices rise (red line going down) margins tend to contract (blue line going down). Any upside materialization in import prices would simply add to the already strong forces putting downward pressure on profit margins.