Profit margins are elevated in the historical context, and have started to soften… they always move lower ahead of the next downturn…

…net interest component was strongly accretive to corporate bottom line over the past few years, with net interest expense collapsing, but this is likely as good as it gets…

…ULCs are set to move higher, as well… this shoud lead to a rollover in margin proxy - deflator minus ULCs

Source: FRED,J.P. Morgan.

• Bulls are to a good extent basing their constructive market call on the premise that corporate profits are set to accelerate, supported by the bottoming out in activity indicators that is now in progress, such as PMIs and ISM. Indeed, a number of forecasters have in the past few weeks raised their index targets on the back of the more optimistic earnings outlook. However, the earnings reality might turn out to be the opposite as we move through the year.
• In aggregate, and despite a few notable exceptions, corporate profit margins are elevated in a historical context, and appear to be peaking out - top chart. The historical pattern where profit margins always start to move lower ahead of the next economic downturn is clear. We see 3 sources of downside to profit margins and to earnings from here:
• 1. Many corporates benefitted from the unique feature of this cycle: as interest rates increased 300bp+, the net interest expense came down. That could be explained by companies locking in low cost of financing through extending the duration of their debt, and also through many corporates seeing an improving return on their cash balances. This, rather counter-intuitive, development is set to normalize as time passes. Companies will have to roll their debt into higher cost of credit. Separately, the basket of stocks with high refinancing needs is losing 20% vs SXXP over a year ago - JPDEHFCL, and our basket of cash rich companies is ahead by 14% - JPDEHFCW. We think this outperformance will continue through 1H.
• 2. Topline was exceptionally strong post COVID for many corporates, as pricing power was high, companies were able to pass on input cost pressure with ease. As nominal GDP growth rates fade, and as PPIs have turned negative, margins could weaken. We are still of the view that COVID induced inflation spike will end up fully unwound, as per our Oct ’22 report, and this in turn suggests that corporate profitability winners need to reset. Historically, the positive correlation between earnings and PPIs has been clear.
• 3. US economic activity was much more robust last year than most assumed, and this has potentially boosted productivity and in turn reduced ULCs. If the economy slows, partly because the supports that it enjoyed last year do not repeat, such as fiscal stimulus, ULCs could pick up. Profit margin proxy, corporate deflator minus ULCs, could turn into more of a headwind.
• Putting the above 3 together, one might end up with a disappointing profits outcome even without seeing an outright recession, and we note that 2024 EPS projections keep coming down in key regions. Now, could S&P500 earnings do much better than economy wide profits? It is interesting to note that for S&P500 all the profit growth in the past few quarters was due to Magnificent 7, and this is one of the reasons why we remain OW Growth vs Value.  Ex these stocks, EPS growth for the remaining S&P500 constituents is outright negative. USD plays a role here, and if it gets stronger, as we suspect, then the S&P500 earnings might not outperform NIPA much.

Figure 1: S&P500 EPS vs Trend

Source: Datastream, IBES

Consensus projections are for S&P500 EPS growth to accelerate in 2024 and 2025, to 10-11% pace, from 2% seen in 2023. Bulls are basing their constructive market call on this, but the question is whether earnings and margins will continue to grow from what is an already elevated starting point?

Profit margins are elevated, and starting to show some softening of late...

Figure 2: NIPA profit margins

Source: BEA

US profit margins are close to historical highs, and are softening from the peak levels. We note that the rollover in margins always historically preceded the next downturn.

Figure 3: MSCI Europe (ex Financials) EBIT margin

Source: Datastream

European profit margins are also at elevated levels, in the historical context. Some sectors such as commodities and Chemicals are subdued, but most other sectors are at highs, leaving the overall margin level elevated.

The consensus is projecting an acceleration in EPS growth and in margins this year, but we see risks to this.

...we believe profitability trends will be weaker over the next year: 1) Corporate profit margins have benefitted from lower interest expense. but that could start to reverse

Figure 4: Euro IG and HY Yield

Source: J.P. Morgan

Compared to pre-pandemic levels , the yield on the Euro denominated investment grade credit has gone up more than 300bp, from 0.9% in 2019 to 4.2% on average in 2023. Cost of borrowing for high yielders has risen by 380bp over the same time frame.

Figure 5: US HG and HY Yield

Source: J.P. Morgan

US corporate debt has seen yields rising by similar magnitude.

Figure 6: US and Eurozone Median Net Debt to Equity

Source: Datastream

At the same time, net leverage of both the US and European corporates has not changed all that much, to be close to the historical averages.

Figure 7: Nonfinancial corporate business: Net Interest Expenses

Source: FRED

What is interesting is that despite the big increase in borrowing costs it appears that companies are on average paying less in interest now than before the pandemic. Data from the St. Louis Fed tracking aggregate interest expense for non-financial corporates in the US shows a sharp decline over the past few years.

Figure 8: S&P500 and Stoxx600 Net interest expense as a % of Net Debt

Source: Bloomberg Finance L.P.

Our bottom up analysis on S&P500 shows that almost 40% of the index constituents have either seen their net interest expense go down, or the income on their cash balances improve compared to 2019. For Stoxx600, more than half the companies are paying less in interest expense versus 2019, or are earning more interest on their cash balances.

We also looked at the effective interest rate (net interest expense / net debt) that companies were paying on their debt. Here again we note that 42% of companies in the S&P500 (excluding net cash companies from the denominator) and 36% of companies in the Stoxx600 are paying a lower rate of interest on their debt versus the pre-pandemic levels. This finding is supported by work from our Credit strategists who concluded that, at an aggregate level, as a rate of change vs 2019, companies were net earnings more interest on their cash balances compared to what they were paying in additional coupons on their debt.

The reasons why this happened range from: a large number of corporates tapped debt markets during the period of extremely low interest rates, extending the duration of debt on their books, and locking in low cost of financing, which didn’t need to roll over yet, and at the same time on their cash balances companies started to earn some positive rate of return. We do not think that can last, the positive effect is as good as it gets, in our view.

Figure 9: European and US High Yield bonds maturity profile (EUR billion)

Source: J.P. Morgan Credit Strategy

Limited refinancing needs thus far meant that, at an aggregate level, companies were largely shielded from the higher borrowing costs. This is starting to change. We note that a growing volume of debt is to be refinanced over the next few years. At the same time, we expect central banks will commence rate cuts this year, which will reduce the income on cash that corporates are earning.

In Europe, quite a few companies in the Technology, Industrials and Consumer Discretionary sectors need to refinance a significant proportion of their debt over the next year.

The Consumer Discretionary, Technology and Real Estate sectors in the US have relatively high proportion of shorter duration debt.

Figure 10: Nonfinancial corporate business: Net Interest Expense versus US 10Y bond yield

Source: Bloomberg Finance L.P., FRED

This suggests that the startling divergence that was seen between the rising interest rates and falling net interest expense seen over the past 3 years is set to start closing.

Our analysts have flagged stocks like Safran, BAE systems, Sanofi, GSK and Novartis among those that have benefitted from this.

The basket of stocks with high refinancing needs will likely keep struggling...

In our 2024 outlook report, we had introduced a couple of stock baskets centered around this theme.

On the negative side, we identified companies that have high leverage and face meaningful refinancing risk in the near-term.

…while cash rich companies should keep working in the near term

On the other hand, we argued that companies that are cash rich, or benefit from still high interest rates, will be well positioned.

Figure 11: JPM Beneficiaries of higher rates basket relative

Source: Bloomberg Finance L.P.

This losers basket has lagged the Stoxx600 index by almost 20% over the last year, while beneficiaries basket is outperforming the Stoxx600 index by 14% since the start of last year. We believe this trend should continue, at least in the 1H of this year.

2) Corporate topline was very strong post COVID, with high pricing power, but these are not sustainable

Figure 12: USD GDP Deflator

Source: J.P. Morgan

Corporates benefitted from the very strong topline growth post COVID. Many had like-for-like sales growth of a magnitude never seen before. This was helped by strong consumer backdrop, supported by ample liquidity.

Figure 13: US Manufacturing PMI - Supplier Delivery Times

Source: J.P. Morgan

At the same time, the supply chain distortions created by COVID-related shutdowns created huge supply-demand imbalances. While this at face value increased costs and resulted in production outages in a wide range of industries, companies were able to more than offset any negative impact on their bottom-line through aggressive pricing.

Figure 14: US Retail trade - Motor Vehicle Inventory/sales

Source: J.P. Morgan

We believe that this period of very strong pricing power is ending. Inventory levels across a number of industries are normalising, as are sales.

Figure 15: MSCI World12m trailing EPS and Global PPI

Source: Datastream, J.P. Morgan

As PPIs turn negative, corporate earnings will likely follow.

Figure 16: MSCI Eurozone 12m trailing EPS and Euro area PPI

Source: Bloomberg Finance L.P., Datastream

Producer prices have seen bigger declines in the Euro Area, and the positive fit is as good.

3) ULCs could pick up as topline slows, and as wage costs are sticky

Figure 17: Unemployment rate and avg hourly earnings

Source: FRED

The strong improvement in productivity was a big factor behind the resilience in margins over the past year, but that could have been flattered by elevated topline growth, which was supported by one-off factors such as excess liquidity and the aggressive government spending. Even though the labour market was extremely tight and delivered higher wages, the strong output has kept unit labour costs in check.

Figure 18: Euro area negotiated pay growth

Source: J.P. Morgan

US wage growth has peaked, but could stay elevated for a while. Eurozone wage growth also appears to be peaking, but at elevated levels.

Figure 19: GDP Deflator minus ULCs - US

Source: J.P. Morgan, FRED

Looking forward, wages will likely remain sticky around current elevated levels, and productivity might slow, as topline slows. Our margin proxy (GDP deflator minus ULCs) has peaked and we believe it will continue to weaken further.

Earnings projections are continuing to be revised lower...

Figure 20: Weekly EPS revisions for key regions

Source: IBES

EPS revisions remain negative for all major markets, Japan being the notable exception, where we keep our key OW.

Figure 21: MSCI Europe sectors 2024 EPS - change ytd

Source: IBES

Except Retail, every European sector has seen cuts to its 2024 earnings projections in the last couple of months.

Figure 22: MSCI US sectors 2024 EPS change ytd

Source: IBES

Even in the US, which has delivered stronger EPS growth, most sectors have seen downgrades to 2024 earnings projections.

...all the EPS growth is still narrowly concentrated in the Magnificent 7...

On the surface, S&P500 earnings delivery of 7% y/y in Q4 appears healthy.

Figure 23: S&P500 sector contribution to 4Q’23 earnings growth

Source: Bloomberg Finance L.P., J.P. Morgan

However, we note that ex the magnificent 7 (Apple, Microsoft, Amazon, Nvidia, Meta, Tesla and Alphabet), US earnings growth is actually negative at -4% y/y.

For the whole last year, Magnificent 7 earnings grew strongly, and the remaining 493 stocks recorded negative EPS growth.

Figure 24: Magnificent 7 and S&P500 performance

Source: Datastream

The divergence in earnings for the Magnificent 7 stocks and the rest of the market largely explains the wide divergence in relative performance over the last year.

...we maintain OW Growth vs Value stye...

Figure 25: MSCI World Growth vs Value 12m Fwd. EPS

Source: Datastream

Similarly, we note that Growth stocks have been delivering much better earnings compared to Value.

Figure 26: MSCI US and Europe Growth vs Value

Source: Datastream

This is behind our continued preference for Growth over Value style that we held through 2023, and are continuing this year.

...S&P500 earnings are more international than NIPA profits… if USD strengthens, S&P500 earnings might not be able to outperform NIPA

Figure 27: USD net positioning

Source: J.P. Morgan

The question is could S&P500 earnings perform better than NIPA profits. Perhaps not if USD strengthens, as S&P500 earnings are typically more international than NIPA profits. We note that USD positioning is not very stretched at present, and the interest rate differential could work in support of USD as we move through this year.

So far this year, US is ahead of International, Growth is outperforming Value, large caps are again beating small, and China continued struggling. We believe that this, ultimately unhealthy, high concentration and narrow leadership is set to continue until something breaks. To buy Value, beta and International stocks, one needs to see a reflationary backdrop, in our view, but we could have the exact opposite. The risk is of a disappointment on both sides of the Goldilocks narrative. Fed cuts might still be overdiscounted, despite the recent hawkish repricing, and the chances are that inflation picks up again, supply side driven, rather than due to stronger activity, freight rates have nearly tripled. We believe our long duration call made in October will have legs in 2024, but have argued at the start of this year that yields will likely consolidate near term, and the USD could be bottoming out. Regionally, we have preferred US to International stocks since May of last year, and don’t see that changing yet. We remain cautious on China, keep fading the bounces, and keep OW Japan – it remains our top regional pick. We are OW Growth vs Value, continuing our call from 2023, and continue to be UW Banks call started in Q4 of last year, after three years of Banks beating the market.

Figure 28: DM Equity Fund flows – last month

Source: EPFR, Japan includes BoJ purchases.

Figure 29: DM Equity Fund flows – last 12 months

Source: EPFR, Japan includes BoJ purchases.

Figure 30: Cumulative fund flows into regional funds as a percentage of AUM

Source: EPFR, as of 7^th Feb, 2024. Japan includes Non-ETF purchases only.

Figure 31: Cumulative fund flows into regional equity ETFs as a percentage of AUM

Source: Bloomberg Finance L.P. *Based on the 25 biggest ETF's with a mandate to invest in that particular region. Japan includes BoJ purchases.

Figure 32: S&P500 RSI

Source: Bloomberg Finance L.P.

Figure 33: EuroStoxx50 RSI

Source: Bloomberg Finance L.P.

Figure 34: AAII Bull-Bear

Source: Bloomberg Finance L.P

Figure 35: Put-call ratio

Source: Bloomberg Finance L.P.

Figure 36: Sentix Sentiment Index vs SX5E

Source: Bloomberg Finance L.P.

Figure 37: Equity Skew

Source: Bloomberg Finance L.P.

Figure 38: Speculative positions in S&P500 futures contracts

Source: Bloomberg Finance L.P.

Figure 39: VIX

Source: Bloomberg Finance L.P.

Table 16: Sector Index Performances — MSCI Europe

Source: MSCI, Datastream, as at COB 22^nd Feb, 2024.

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Anamil Kochar (anamil.kochar@jpmchase.com) of J.P. Morgan India Private Limited is a co-author of this report.