The U.S. Bureau of Economic Analysis released their second estimate of Gross Domestic Product (“GDP”) and Corporate Profits (“profits”) on Wednesday. GDP increased at an annual rate of 2.1 percent in the second quarter of 2023, up from the first quarter’s 2.0 percent (revised downward from the initial second quarter estimate, however). Profits of domestic nonfinancial corporations increased $17.1 billion in the second quarter, significantly stronger than the decrease of $102.9 billion in the first quarter.
- Disposable personal income increased 5.9 percent in the second quarter, an upward revision of $36.3 billion from the previous estimate.
- Real disposable personal income (adjusted for inflation) increased 3.3 percent, an upward revision of 0.8 percentage point.
- The Personal Consumption Expenditure (“PCE”) price index increased 2.5 percent, a downward revision of 0.1 percentage point. Inflation, by this measurement, is down significantly from its post-pandemic peak of 12 percent. Excluding food and energy prices, the PCE price index increased 3.7 percent, a downward revision of 0.1 percentage point. Inflation minus the more volatile food and energy components continues to trend lower and is down from its post-pandemic peak of 6 percent.
From a “personal” point of view, the data is favorable as income has continued to increase and inflation has continued its downward trajectory – this has led to the “real” increase in disposable income of 5.98 percent since the first quarter.
What we would like to focus on, however, is the corporate profits component of the release. Corporate profits after-tax increased 2.5 percent from the first quarter, reversing the recent downward trend (they are, however, still down 9.3 percent from the same quarter one year ago). Rather than view [non-financial] corporate profits as a stand-alone number, we find it is more useful to express this as a percent of “Gross Value Added of Non-financial Corporations”, a proxy for corporate profit margin.
As the charts below evidence, while corporate profit margins are down from their peak of 17 percent (set in March of 2021) they remain above their pre-pandemic levels. The ten-year pre-pandemic average is slightly North of 11 percent and corporate profit margins are currently North of 14 percent.
Margins are similarly over 2 percent above their post-GFC (Global Financial Crisis) average of 12 percent:
Profit margins continuing to remain above average imply that pricing pressures have been able to be passed on to the ultimate buyer and the prices of their raw materials have fallen. When viewed through this lens, there continues to be a tailwind for risk assets (most notably equities). This, of course, would be wonderful news if we could leave it at that, but alas, we cannot.
Labor unions haves shown renewed strength in their ability to negotiate more favorable compensation packages. The UAW has recently authorized a strike if their negotiators cannot secure an attractive contract package, American Airlines flight attendants have done the same. Recently, we have seen labor win favorable packages at UPS, and organize at Amazon and Starbucks. If labor continues to make gains, corporate profit margins will be harder to sustain.
Similarly, on-shoring and “friend-shoring” as well as the regionalization of suppliers has begun to increase costs. Should the reorganization of suppliers continue to follow geopolitical lines, there will be costs involved that will also impact profit margins.
Tailwinds of margins, when combined with the cross currents of labor and suppliers combine to potentially create turbulence in the trajectory of corporate profits and economic health which ultimately affects valuations. Valuations, represented by the price/earnings ratio (how much are investors paying for $1 of company earnings) are currently elevated relative to both pre-pandemic and post-GFC periods. The charts below show the extent:
First, the S&P 500, a large cap stock index, is trading at 21 times earnings versus the 17 times earnings average since 2010:
Lastly, the Russell 3000 index, a broader-based index which represents approximately 98 percent of the domestic investable market is trading at approximately 22 times earnings versus the 19 times earnings average since 2010.
The bottom line, in our opinion, is that equity valuations are a touch rich for the economic environment we are potentially heading into. Valuations are high, in part, due to the resilience of corporate profits during the post-pandemic, inflationary period – which may not be sustainable. As always, a portfolio of diversified assets helps reduce the potential negative impact of any one asset class and helps investors progress towards their financial goals.
The views stated in this blog (report) are not necessarily the opinion of Cetera Advisors LLC. Due to volatility within the markets mentioned, opinions are subject to change without notice. Information is based on sources believed to be reliable; however, their accuracy or completeness cannot be guaranteed.