Portfolios must shift as US corporate profitability falls

Earlier in the year, I predicted that corporate profitability would fall as US corporate profit margins were cyclically high. The New York Times is reporting that corporate profits fell in Q1 2012 for the first time since the fourth quarter of 2008. I expect this trend to accelerate.

There are a number of things behind the uptick in profits:

1. Corporations have cut headcount significantly due to the recession and subsequent slowdown in growth in the US. This has given firms greater operating leverage as the economy has improved because firms have been slow to increase headcount.
2. US firms receive a large chunk of their profits from abroad and increasingly from emerging markets where growth has been more robust than in the US.
3. Large government deficits are balanced by large nongovernment surpluses. And while households have increased savings, household sector surpluses are limited by the lack of income and job growth, meaning that most of the benefits of deficit spending have gone to the business sector in the form of higher profits. Think of it as a business sector subsidy that is supposed to trickle down to households and individuals via eventual payroll increases.

From a US macro perspective, with profit margins cyclically high, the skew toward business deleveraging combined with a lack of household income growth will be a drag on profitability from US operations. The US is doing relatively better than Europe and so profits are increasing domestically. However, with the synchronised global growth slowdown picking up steam, overseas profitability has fallen and will continue to fall. The New York Times says profits from domestic businesses rose at an annualised $41.7 billion rate in Q1 2012, Overseas profits decreased at a $48.1 billion annualised rate.

I continue to expect US equities to underperform for the full year 2012 as compared to their European counterparts. Because of the sovereign debt crisis, European equities offer a significant relative value over US equities. According to Bloomberg, the Euro Stoxx 50 Index is trading at a discount to book value at 0.9 times book value. This is the cheapest ever outside of the week shares bottomed in March 2009. With US profits falling, European shares represent better value at this time.

Source: Corporate Profits Fall for First Time Since Recession – NYTimes