Market commentators forecasting further expansion in corporate profits are living in a “parallel universe”, with a number of indicators showing the likelihood of falling profitability, says Hugh Selby-Smith at Talaria Capital.

Selby-Smith said that established relationships between interest rates, leading economic indicators, and corporate earnings all point towards falling profitability into the second half of 2023, which will negatively impact markets.

“After a pandemic low in early 2020, profitability recovered sharply to reach record highs, and, following the latest earnings season in the US, some analysts are forecasting further expansion.

“In our view, these analysts are living in a parallel universe because there is a swathe of data highlighting the risk to corporate profitability. For example, corporate profits as a percentage of GDP are at a 75-year high.

“At the same time, these record levels of profitability have coincided with depressed growth in unit labour costs. But with twice as many job openings as unemployed persons, according to the US Bureau of Labour Statistics, wage growth is picking up aggressively. Furthermore, interest costs and tax are impacting on profitability,” he said.

“It is an understatement to say it is difficult to see how future profitability is going to experience tailwinds. We know that interest rates are up, and even if the recently passed Inflation Reduction Act did no more than try to limit corporate tax avoidance through a 15 per cent minimum, it does suggest the direction of tax travel is no longer south.

“It is perhaps telling that in the latest earnings season in the US, many companies are not offering forward guidance – only about 20 per cent offered guidance compared to a more usual 70 per cent or so. It is notable that these companies do not feel confident about making these sorts of forecasts in the current environment. At the same time, the market has more actively punished those offering poor guidance than those withdrawing guidance.”

Selby-Smith said that the golden period of returns since the global financial crisis has lulled many investors into a false sense of security.

“The elevated margins and rich valuations experienced since the GFC have contributed to a golden period for investors.

“But deeper analysis is important. Breaking returns further down into changes in sales, EBIT margins, tax, interest, and valuation, it is striking that operating margin expansion accounted for one third of that return.

“If nothing else, given the record level, it throws the responsibility on the optimists to explain why the future should be the same, or indeed why there should be a positive contribution at all.

“The third most important component was valuation, which accounted for one fifth of the return. Again, we would be interested to hear the case for a similar, or even for a lower but positive contribution over the next decade,” he said.

Source: Bloomberg

With all this in mind, Talaria has forecast a ten-year prospective return for the S&P 500* in terms of upside, central and downside models.

The most optimistic scenario is a prospective long run average annual nominal return of 6.1 per cent (4.1 per cent real after deducting the Fed target assumption of an average 2 per cent) but [name] says the underlying assumptions require an extremely optimistic viewpoint.

A central case arrives at a prospective long run average annual nominal return of 3.6 per cent (1.6 per cent real). A downside case is a prospective long run average annual nominal return of -1.4 per cent (-3.4 per cent real).

“What none of the models show is that the long-run return would almost certainly be bumpy and, in the downside case, the market might well rebase first, falling to reflect a combination of earnings’ downgrades and valuation contraction,” Selby-Smith said.

“On the plus side, any decline improves the outlook for returns, and should markets rebase this should provide a materially better starting point for investors to add to risk.”