Probably the most impressive development in the investment universe in the last couple of years has been the dramatic growth in US corporate profits. The question is whether these record profits are sustainable because of the continuing crisis in the Eurozone, according to Paul Chew, Head of Investments at US equity specialists Brown Advisory.
The impact of the austerity measures on the EU economies could be severe. Nearly 50% of Eurozone GDP comes from government spending, which is almost double that of the US. As country after country in the Eurozone cuts spending further, the odds of EU GDP turning negative increase.
A European recession would clearly hurt US exports to Europe, but the US economy is not overly exposed as the EU only represents approximately 20% of the total US export market. Demand growth in the emerging markets should help to counteract any downturn in Europe. Moreover, the strength of corporate balance sheets in the US should help to alleviate the potential impact of any tightening of global credit caused by a more restrictive lending environment in Europe.
On US corporate profits, historically S&P 500 earnings have grown twice as fast as GDP. In 2011 S&P 500 earnings have risen a remarkable 15% while GDP expanded just 1.4% annualised. US corporations have generally delivered exceptional numbers by squeezing every last dollar they can out of sluggish sales through tight cost controls. Of course the focus on profits has kept a lid on new hiring, leaving the unemployment rate at around 9%. The pre-tax margin for S&P 500 companies has gone from 4.4% during the recession of 2008 to 12%.
The frustration in 2011 was the dichotomy between the macro and micro data. Whilst many companies reported stable demand and business fundamentals, these attributes mattered little when the market was fixated on the European debt crisis and fragile global recovery. Volatility and thematic investing were the trends last year.
Equity valuations however are relatively compelling, even if corporate-profit growth moderates, as I expect it to. The S&P 500 is currently trading well below its five, 10 and 20-year price/earnings averages and in general I am pleased with the performance of the majority of Brown Advisory’s portfolio companies in such turbulent conditions.