The Curious Incident of the Elevated Profit Margins

Executive Summary

This is the first in a series of papers that seeks to explore why U.S. profit margins have remained elevated for the last 10 or so years compared to history. I look back to a paper written just over a decade ago in which I predicted a return to normal profit margins. I obviously couldn’t have been more wrong. In this paper, I return to the framework of the Kalecki Profits equation to understand the macro source of my error.

It transpires that fiscal deficits have been the culprit. Between 1950 and 2011, the fiscal deficit averaged just less than 3% of GNP each year. In the period from 2012 to 2022, the fiscal deficit was more than double the previous average, at 6.6%. This isn’t just the impact of the pandemic: the same basic pattern holds even when I exclude the Covid years! The main sources of the increased deficit have been health spending and social security expenditure (again true even with Covid data excluded). Is this era of what Minsky would have called “Big Government” here to stay? That is beyond my ken, and I am chastened by my failed prognostication over the last decade.

However, even if I take a very bullish view, that this is indeed a new era of permanent deficits and thus profit margins will remain elevated relative to history, I still cannot find any valuation attraction in U.S. equities in aggregate. The Shiller P/E naturally embodies the decade of higher-than-normal profit margins and yet still stands at 30x. Even without any valuation or margin mean reversion, this dooms investors to low returns in the long run. Any moves toward either valuation or profit margin reversion make this return even worse. Measures of margin-adjusted CAPE show the U.S. to be trading on 45x to 50x! Either way, the aggregate U.S. market looks to be priced for something beyond perfection. There simply isn’t a margin of safety.

The good news is that other markets look considerably more attractive than the U.S. Emerging Markets, Europe, and Japan all offer much better-expected returns than the U.S. If one is willing to dig a little deeper, then Value within these markets (and even Deep Value within the U.S.) looks like the best hope for generating decent returns. For instance, Value within Emerging Markets is trading on around 7x Shiller P/E…talk about discounting the bad news!