Compared to prior estimates, the Bureau of Economic Analysis’ annual revisions to the income and product accounts reveal weaker corporate profits and lower margins.

Declining profit margins are quite typical in the later half of economic expansions. As such, the revisions serve as further confirmation of our view that the US expansion is near its peak.

The last year or so has presented a quandary for those who track corporate profit margins as an economic cycle indicator. We have seen a number of indications that corporations have been experiencing unfavorable margin pressure, but the Bureau of Economic Analysis (BEA) continued to estimate decent profit growth and stable margins over recent years. This seeming inconsistency has now been resolved with the BEA’s annual update to the national income and product accounts, which revised five years of gross domestic product data. With the latest estimates, total corporate profits were revised lower by over $300 billion for 2016-2018. Furthermore, the revisions suggest that profits peaked in 2014. Put differently, in the aggregate there has not been a meaningful recovery from the 2015 profit recession.

With the latest revisions, profit margins have now clearly been on a downtrend since 2014.1 While non-labor costs rose over this period, higher worker compensation was a significant driver of the decline in margins.2 More importantly for the economic and market outlook, Figure 2 highlights how profit margins have evolved over economic cycles, rising in the immediate aftermath of recessions as pared-down labor costs increase per-unit profits, before falling later in expansions as profit growth slows and labor and other production costs eventually rise. With this historical perspective, the decline in corporate profit margins in recent years serves as another indication that the current expansion is in its later stages.

Figures 2 also illustrates that even after peak profit margins, stock market returns can continue to rise, often for several years. An important reason for this is the market focus on earnings per share and actions by corporations to boost this metric through buybacks. Often, buyback activity picks up well before peak profits. This likely reflects corporate management anticipating slower earnings growth later in the cycle and acting proactively to support future earnings when measured on a per-share basis. This dynamic can be seen in Figure 3. The orange boxes highlight periods with a falling S&P 500 index divisor3, which we view as a proxy for periods of elevated buybacks. In both the 1983-90 and 2004-07 episodes of share buybacks, annualized profit growth turned out to be quite anemic despite a mid-cycle run-up, but buybacks supported EPS growth, which in turn supported multiple expansion and higher stock prices―at least until evidence of a brewing recession became too widespread to ignore (see final table for details).

Looking forward, consensus expectations are for earnings-per-share growth to trough this quarter, before turning positive later in the year and picking up further in 2020. For this to occur, firms will need some combination of improved top-line revenue growth and less pressure on margins. The first is certainly possible, but will require an improved domestic and global growth backdrop, which itself is reliant on more significant global monetary policy accommodation and a reduction in the uncertainty resulting from the US-China trade dispute.4 As for margins, significant labor scarcity suggests that labor costs will continue to rise. In short, we believe that current estimates of EPS growth are too optimistic. Of course, companies can again attempt to prop up EPS growth through share buybacks. However, with corporate leverage already elevated and economic growth slowing, evidence already suggests that equity investors are no longer rewarding companies for engaging in buybacks at this point in the cycle.

Portfolio Implications

Along with an inverted Treasury yield curve and evidence of a tight but cooling labor market, we view the data on shrinking corporate profit margins as another late-cycle signal. Rising tensions in the US-China trade relationship only add to our conviction that the expansion is near its peak. As for portfolio implications, the recent underperformance in lower-rated portions of credit markets may provide some tactical opportunities to add risk. Overall, however, we believe that our reduced risk posture in portfolios remains appropriate. This includes an orientation towards higher credit quality, a shortening of spread duration, and over-weighting noncyclical sectors relative to cyclicals.

1 Our analysis focuses on pre-tax margins, which give a better sense of underlying trends in corporate profitability and cash flow. On an after-tax basis, in light of the 2017 Tax Cuts and Jobs Act the decline in profit margins is less pronounced but still quite meaningful.

2 Over this period, the price per unit of real gross value added rose 6.7 cents, while per-unit compensation of employees rose 6.8 cents. Bureau of Economic Analysis, advanced estimated of Q2 2019 GDP, Table 1.15.

3 The S&P divisor is a scaling factor that serves to equate estimates of total market capitalization for the index over adjacent periods. The divisor changes in reaction to corporations entering and exiting the index, but also in response to corporate actions such as share issues and repurchases and other stock-related transactions. The divisor is also used to calculate the earnings per share measure for the entire index, i.e., total earnings of all 500 companies divided by the index divisor. See for example, David Blitzer, “Inside the S&P 500: PE and Earnings Per Share,”, February 7, 2014,

4 To our thinking, the recent escalation in US-China trade tensions has already offset the effect on financial conditions of the FOMC’s first rate cut. Meanwhile, policy easing by other central banks has precluded any weakening of the trade-weighted dollar.