Margin Meltdown Just Starting, Says JPMorgan

While the sample is small, history suggests that readings below zero have boded poorly for margins. Over the last three decades, the wage-price spread had turned negative on two occasions outside economic recessions, in 1986-1989 and in 1996-1999, data compiled by Bloomberg and JPMorgan show. In both cases, profit margin kept shrinking amid persistent pressure from higher wages.

In the classic cycle, margin contractions don’t last until an economic acceleration convinces companies to boost hiring and capital spending beyond what sales warrant. That’s unlikely today because growth is too slow and companies are cautious about raising wages, according to Andrew Slimmon, Chicago-based portfolio manager who helps oversees $5.1 billion at Morgan Stanley Investment Management.

‘Stingy’ Managers

“It’s unclear to me if profit margins declining are necessarily going to cause this big disaster that everyone thinks they will,” Slimmon said. “I don’t believe in this big economic recovery so I’m dubious how much wage growth we’ll truly have. Corporate managers have been very stingy.”

JPMorgan’s Matejka calculates corporate profit margin, based on National Income and Product Account data provided by the U.S. Department of Commerce. While the so-called NIPA margin is at best a rough guide for the S&P 500 since the latter represents the largest American companies with more leeway in managing costs, the two have shown similar trends historically.

The damage of lower margins was visible in S&P 500 profits during the 12 months through September. Over the period, the measure of profitability narrowed by about 120 basis points and the quarterly profit drop accelerated to 3.1 percent.

Analysts surveyed by Bloomberg estimated sales will rise about 4 percent in 2016 and, with the help of a margin increase of 33 basis points, profit will climb 7 percent.

Under that revenue scenario, S&P 500 profit growth turns negative should margin narrow by 40 basis points. The decline would worsen to 1 percent if margin fall by 50 basis points and 6 percent should the contraction reach 100 basis points.

Tobias Levkovich, chief U.S. equity strategist at Citigroup Inc., said the price-wage gap tends to lead corporate profit margin by two years. The fact that it has turned down suggests a “reason for caution’’ next year, he wrote in a note to clients Thursday.

JPMorgan studies market and economic cycles since World War II and found that on average, the peak in profit margin came five quarters before the end of the bull market and seven quarters before the start of an economic recession.

“We are concerned that the positive drivers of profit margins are getting exhausted,” Matejka wrote in a note published last week. “If margins have really peaked, the next downcycle is getting nearer.”