A number of factors seem poised to put pressure on corporate profits, likely creating a headwind for equity markets in the years to come, says Morningstar's Bob Johnson.
Bob Johnson: Corporate profits are a key driver of stock market activity. Over the past couple of decades, profits have grown considerably faster than GDP. This caused profits to take an increasing share of GDP, peaking at about 10% or so. That's well above the long-term average of about 6.5%.
So, what drove that increase? Well, certainly, very low labor costs helped during that period of time along with very low interest rates and pretty attractive productivity growth. You combine all of those and we had an increasing share going to corporate profits. However, over the last couple of years those profits have begun to decline again.
Why is that? Well, we've certainly had an unfavorable commodities experience with oil, in particular, going down, and oil is not an insignificant part of corporate profits. Certainly, labor costs have increased with increasing labor shortages as well, and productivity growth isn't what it used to be, all depressing corporate profits. Unfortunately, the prognosis for profits going forward is not particularly good. Labor costs are just beginning to accelerate frankly and we also expect the commodities cycle to last a little bit longer, and probably interest rates will eventually move higher.
That's not great news for equity markets. During periods of rising profit, markets have performed much better than periods when profit growth is slowing. Since the 1950s markets have risen about 15% or so during periods of rising profits but only 9% when profit growth is slowing. Looking at this data, it would suggest that as profits slow in the years ahead that equity markets will face a headwind, but not necessarily a disaster.
