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Profits Looking Toppy: Will Margins Crumble?

July 25, 2013 By Young Research

We’ve been pointing out for some time that after tax corporate profits as a percentage of GDP were much higher than their historical average, and that a mean reversion should be in the works. It does appear as though they’re peaked out, as can be seen on our chart below.

after tax corporate profits

Justin Lahart says in The Wall Street Journal that, based on analysis by Brett Gallagher, the Fed’s artificially low interest rates are to blame for the run up in profit margins. He says that as rates rise, there could be winners and losers.

But an analysis conducted by independent strategist Brett Gallagher shows that low interest rates have done much to bolster margins. Given the superlow interest-rate era may soon start drawing to a close, that could be another reason for investors to question just how long margins can hold up.

The one-year London interbank offered rate, a key benchmark for companies’ short-term financing costs, has fallen to 0.7% from 4.2% at the end of 2007, when the last recession began. The effective yield on investment-grade corporate debt, according to the BofA Merrill Lynch Corporate Master index, is now 3.3%.

That is well below the 5.8% it logged at the end of 2007, but up from a record low of 2.6% in early May, before the Federal Reserve suggested it was considering winding down its Treasury- and mortgage-bond-buying program this year.

The lower rates have helped companies substantially lower their interest-rate costs. Mr. Gallagher found that in 2012, interest expenses—what companies had to pay to service their debt—came to 1.8% of sales for companies in the S&P 500. That compares with a 15-year average of 3.9%. Nor does this reduction in interest expense reflect a reduction in debt: Net debt as a percentage of assets stood at 14.2%, above the 15-year average of 11.5%.

The upshot is that as interest rates rise, companies will find it difficult to maintain profit margins. But as is often the case, there will be haves and have-nots.

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