C.J. Lawrence Weekly – Peak Margins? Not Yet.
The U.S. Benchmark 10-Year Treasury Bond Yield closed at 3.07% on Friday, up 8 basis points for the week, continuing its recent uptrend. In fact, the 10-year yield is up 22 basis points in the last month. Despite strong demand for treasuries, which tends to suppress yields, the 10-year treasury yield is approaching its one-year intra-day high of 3.11%, set back in May. Prior to the May peak, it last nicked 3.0% in January of 2014. The Federal Reserve Board is expected to raise the Fed Funds Target Rate by 25 basis points at its Wednesday meeting, so the increase at the long end of the yield curve is welcome news to those fearing yield curve inversion and indicates that market confidence in U.S. economic growth remains intact.
Those looking at the stock market glass as being half empty will point to rising rates as a headwind for corporate profits and stock prices. Higher interest rates increase the attractiveness of bonds versus equities and increase corporate borrowing costs. In a classic business cycle, the higher borrowing costs and accompanying employment and goods inflation pressure profit margins. Thus, late in the business cycle, corporate sales can continue to grow while margins compress, putting a lid on corporate profit growth. Some analysts are submitting that we are there now. But an examination of recent margin trends suggests that profit margins have not peaked, and bottoms-up forecasts suggest they will climb to new highs in 2019 and 2020.
The combination of improved corporate operating efficiencies, new process technology, automation, and lower corporate tax rates look to be contributing to a new era in profit margin expansion. The S&P 500 Index trailing 12-month net income margin reached 11.3% in 2Q18 and is expected to rise to 11.9% by year-end 2018, according to data provided by FactSet. If forecasts prove correct, S&P 500 net income margins could reach 12.5% in 2020, buoying profit estimates. While rising inflation and interest rates do in fact provide margin headwinds, it is important to remember that annualized core CPI in August was 2.2%, well below historical averages, and that even a U.S. 10-year treasury yield of 3.5% would be lower than the closing yield in all but 8 of the last 60 years. Instead, should interest rates and inflation continue to rise at a consistent and measured pace, the impact on corporate profit margins may feel less like a headwind and more like an onshore breeze.