The past 25 years have seen many positive forces contribute to corporate profit margin expansion globally, which in turn has propelled stocks ever higher on all major exchanges. It is unlikely that this pattern will continue indefinitely.
Decline in Organized Labour
A reduction in labour’s bargaining power due to the decline of organized labour and unions has been a significant contributor to profit-margin expansion. There are many factors driving this trend, with the primary contributors being access to cheaper foreign labour and an increase in the use of automation in manufacturing. Real wages have lagged productivity gains in the major developed world economies since the 1990s, allowing corporations to garner an increasingly larger share of the overall output.
Globalization (how countries are comingtogether as one global economy, making international trade
easier) has grown dramatically since the 1990s. Technology has helped the world become more
integrated (socially, politically and economically) and encouraged pools of capital and labour to come together more efficiently than was possible in the past. Businesses have used this as an opportunity to shift operations abroad and outsource a range of activities that can be accomplished at a reduced cost in developing nations. These changes have lowered labour costs for producing goods and in turn exerted a downward pressure on wages in developed countries. Globalization has also provided opportunities for businesses in developing nations to tap into new, faster-growing markets, thus benefiting sales growth.
The past 25 years have seen high levels of merger and acquisition activities in all developed markets. Companies buy other businesses in order to grow revenue and earnings - by adding new product lines and expanding into new markets - and to cut costs. An example that is close to home is Canadian Tire. Over the years their acquisitions have included Mark’s Work Warehouse (now branded as Mark’s), Sport Chek and Sports Experts. This rising concentration within a sector generally leads to expanding margins, suggesting that greater pricing power comes from having more economies of scale, less head-to-head competition within a market and a stronger bargaining position against labour.
Falling Taxes and Interest Rates
Corporate tax rates have generally favored businesses over the last few decades. Globally, corporate tax rates are currently at all-time lows. The recent US tax reduction is the largest and most recent cut. We have also seen borrowing costs falling for corporations globally. The sustained reduction in interest rates has been a meaningful support to corporate margins, as companies have been able to fund investment at a much lower cost, thus keeping their debt service expenses at historically low levels.
Looking Forward – Can it Continue?
Global labour costs have moved closer to an equilibrium. Unemployment is at generational lows and there are currently 8 million job openings in the United States - it is inevitable that we will see wage price inflation. Government budget deficits and accumulated debt are at historic highs. It seems probable that over time there will not be upward pressure on corporate tax rates. Interest rates are at historic lows – leading one to suspect that over time there will likely be a reversion to the mean, thus requiring
businesses to fund at higher levels.
While we are still constructive on the public equity markets the forces outlined above encourage us to continue to search out high quality alternative investment solutions for our clients that are not correlated with the public markets.