Trees Don’t Grow to the Sky

We lead off this week with a confession. What follows is not original. We are paraphrasing a terrific report that came from the Federal Reserve earlier this month, titled “The coming long-run slowdown in corporate profit growth and stock returns”. The report very clearly highlights the longer-term impact of the extraordinary monetary accommodation (low interest rates & QE) on the economy in general and, in this particular case, corporate profits.

Since the beginning of extreme monetary policy (the data begins Q4 2002), corporations have embraced lower interest rates, and paid less interest despite increasing levels of debt. In addition, they have paid lower taxes, too. Combine those factors together and you have a very powerful earnings growth engine, but as interest rates rise, that engine is quickly running out of fuel. Neither trees nor earnings grow to the sky.

The implications are that corporate profit growth should slow markedly as long as interest rates stay high. In addition, the proclivity of companies to borrow money to fund stock buybacks is also reduced. That limits a key marginal buyer of stocks over the last 20 years. Slower profit growth and reduced demand would surely be a headwind for stock returns in coming years.

In a nutshell:

Interest and tax expenses have steadily declined as a percent of operating profits from roughly 45% to almost 25%.

The decline above is explained by average corporate interest rates that have fallen from about 5%-6% to about 3%.

And the decline in interest expense was achieved despite increased leverage (borrowing) as measured by debt to total assets rising from a low of 26% to about 35%.

And finally, the effective corporate tax rate has fallen from the low 30% area to 15%.

Putting the pieces together

So how much did lower interest rates and lower taxes contribute to earnings growth over the past two decades? Figure 5 from the Federal Reserve Report attempts to answer this question. The chart shows the real growth for S&P 500 nonfinancial firms (inflation adjusted using the GDP deflator).

Since the beginning of extraordinary policy in late 2002, GDP has grown at 1.8% per annum. Sales growth has been (and should be) very similar at 2.0% per annum.

Earnings before interest and taxes (EBIT) have grown faster at 3.9% per annum. This is a function of improving business conditions over time and therefore higher operating profit margins.

Pre tax Income has grown at a 4.1% rate pre annum reflecting the positive net impact of lower interest rates and rising debt levels.

Net income has grown at a 5.4% clip, benefiting from lower corporate tax rates.

And finally, the market cap of stocks has grown at a 5.9% rate derived from rising P/E multiples (valuations).

Our reading would conclude that the 5.9% growth in market cap breaks down as shown in the chart below, implying that about 1/3 of earnings growth over the last 20 years was the direct result of extremely low interest rates and lower corporate taxes.

With rates now increasing and corporate taxes being nudged higher by the 15% minimum tax, both are headwinds to earnings growth moving forward, assuming interest rates stay elevated. But the only way rates do not stay elevated would be some economic disaster, which would not be positive for earnings anyway. Over time, equity returns are driven by earnings growth and we should expect that earnings growth and equity returns should be lower than the last 20 years over the foreseeable future.

Another stock market impact not captured here is the impact on buybacks, which have become a meaningful source of equity demand. Higher rates reduce the relative attractiveness of borrowing money to fund buybacks, thus further limiting demand for equities.