Return on equity plunged 373bps in 2020, closing the year at 14.6%. That, Goldman’s David Kostin wrote, in his latest, was the lowest since 2016.
Most of the collapse was down to margin compression. EBIT margins exhibited the most pronounced YoY decline since 2009.
“Margin pressure due to the pandemic accounted for 351bps of the total decline in ROE contraction,” Kostin went on to say. As it turns out, record-low taxes and borrowing costs are no profitability panacea during a pandemic (figure below)
The good news is, margins will expand this year and profitability will recover. Or at least that’s the plan.
Between extremely robust economic growth and operating leverage, “margins will increase in 2021, which should support ROE expansion both at the index level and particularly for cyclical sectors that suffered most in 2020,” Goldman wrote, in a note dated Friday.
So, what could go wrong? Well, lots, actually.
Considering there aren’t many centenarians in the C-suite, it’s fair to say that management teams were in totally unfamiliar territory last year. Nobody managing America’s largest companies was alive, let alone old enough to be a decision maker, during the Spanish Flu. So, it’s not as if Julie, CFO, could convene a Zoom call and say something like “We’re extremely fortunate to have Bob on the team. Bob, you’re 187 years old and successfully navigated the last major pandemic. Maybe you can share some of the lessons you learned with the rest of us.”
But it’s not just ambiguity around the trajectory of the pandemic that haunts corporate management. The sheer scope of the damage caused by the virus brought forward the realization of fiscal-monetary partnerships, effectively ushering in an entirely new policy conjuncture with ramifications that are as yet unknown and unquantifiable.
The implications of that policy conjuncture for taxes, bond yields and inflation represent risks to the profitability outlook.
PMIs point to dramatically higher input costs. The effect should subside once bottlenecks and supply chain distortions fade and a robust labor market recovery presumably means consumers would be in a better position to absorb higher prices for goods and services.
But, there are quite a few “ifs” in there. Some supply chain “disruptions” may become fixtures — i.e., permanent or semi-permanent. And if labor market slack persists or the economy doesn’t recover as expected, passing along higher prices to consumers could prove difficult, if not impossible. The figure (below) is from the Philly Fed survey. It’s noisy, but it gets the point across.
“The ability of companies to pass through rising input costs to consumers will be a key determinant of the trajectory of S&P 500 profit margins,” Goldman’s Kostin said, adding that the firm’s basket of companies with low pricing power recently started to lag stocks with higher pricing power after outperforming strongly since the election.
And then there’s rates. “The path of S&P 500 borrow costs (interest expense divided by assets) has closely tracked the path of interest rates,” Kostin remarked. Although Goldman’s projection is for 10-year US yields to end the year at 1.90%, Kostin cautioned that there’s a “plausible scenario” in which they rise as high as 2.40%.
Finally, taxes could bite irrespective of whether the hit to bottom lines is offset by higher sales in a booming economy. “Declining effective tax rates have been the second-largest contributor to ROE expansion during the last 45 years,” Goldman reminds you. Last year, the median S&P 500 effective tax rate was just 18%, the lowest ever.
Goldman recently projected (again) that Biden’s tax plan would reduce S&P 500 earnings by around 9%, assuming it passed as stated.
“Fortunately” (and the scare quotes are there out of respect for everyone who thinks it wouldn’t be the worst thing in the world if corporations paid higher taxes) most analysts, including those at Goldman, expect some manner of compromise.
And besides, pen probably won’t be put to paper on a new tax bill for months. Higher taxes won’t take effect until next year, at the earliest.
God save the corporate bottom lines.