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Are Profit Margins Sustainable: RBC

Stock markets have enjoyed a banner half-decade, forcefully reclaiming the ground lost to the financial crisis, and then some. This vigorous performance has occurred thanks, above all else, to two key enablers: surging earnings and recovering valuations. On the surface, there is nothing especially questionable about either. Earnings naturally rise as economies grow, and valuations recover as risk aversion fades.

However, a closer examination reveals a significant vulnerability within this cozy equation. Corporate earnings growth has been, in a sense, too good – persistently outpacing both revenues and the economy. This has driven profit margins to multi-decade highs.

Worryingly, profit margins have long been assumed to be mean-reverting, arguing that these juicy gains may eventually have to reverse. Such a scenario would necessitate an eye-watering one-third decline in the S&P 500. With stakes as big as these, a clear sense of the downside risk is imperative. This report evaluates the seriousness of the threat by seeking to understand the forces that have propelled profit margins higher, and their likely direction in the future. In so doing, we find that a large number of previously favorable profit-margin enablers are on the cusp of reversing, including the advantages of low borrowing costs, deleveraging, soft wage growth and deferred capital investment. The decline in these drivers suggests that profit margins could suffer.

Fortunately, there are a number of under-appreciated structural forces that continue to support high (and in some cases, even rising) profit margins, including globalization, automation and a compositional shift toward higher-margin sectors.

Grab a cup of coffee (maybe two), sit back and read the full RBC PDF here.

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