Corporate profits ‘likely’ to fall: Talaria

Talaria Capital’s co-Chief Investment Officer has signalled the likelihood of a decline in corporate earnings and profitability, despite other market commentators forecasting otherwise.

Hugh Selby-Smith said commentators who are expecting an increase in corporate profits are living in a “parallel universe”, as rising interest rates and certain economic markers point to a fall in corporate profitability into the second half of 2023.

“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,” he said.

“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.”

Selby-Smith said while the period since the global financial crisis (GFC) may have delivered significant returns for investors, it also presented “a false sense of security”.

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

“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.”