Corporate profits are near all time highs, and high earnings multiples indicate the market expects continued profit growth.  BlackRock’s 2020 Global Outlook identified two key trends that have underpinned high corporate profit margins in recent decades:

Profit margins of publicly listed companies have been on a decades-long march higher. This has been driven by two key trends: globalization (integrated supply chains and labor markets that have, along with technological innovation, reduced input costs) and rising market concentration (the advent of superstar firms that dominate their industries).

As Blackrock noted, if these trends reverse, profit margins could weaken.  As we move into the new decade, there are three main threats to profit margins. 

Profit Cycle and Earnings DErivatives

Trade War

Its not just about the US and China conflict, which seems to alternate between calamity and truce every other day.    For the past few decades, global trade gradually moving towards increased openness. That is starting to reverse. The WTO dispute settlement mechanism has effectively shut down  the Trump administration blocked new appointments to the appellate body. The collapse of WTO’s appellate body is part of a global trend towards populism and trade conflict. At best, there will be a spaghetti bowl of bilateral agreements, instead of the large open multilateral system that existed during the last couple decades.   Companies are now rearranging their supply chains to deal with greater trade policy uncertainty around the world. Companies will need to dedicate more resources to supply chain strategy, ultimately reducing profitability of many companies.

Rising Wages

Wages of many lower paying jobs have remained stagnant for many years, but recent data indicates an increasingly tight labor market.  Higher wages can boost consumer spending and saving, but also negatively impact corporate profits.

Labor Costs and Earnings

Regulation

American businesses will heightened regulatory burdens from many angles in 2020.  First, large winner take industries such as technology will face increasing antitrust scrutiny.  This could drastically alter the fate of BLX Global’s FAANG Revenue Index. Second, the increasing emphasis on sustainability will likely lead to increased environmental regulations.  Additionally, the rise of ESG investing has effectively increased the cost of capital for heavy polluting industries. Finally, concern with climate change is now mainstream and will impact how government regulates business.  If a left of center Democrat wins the US presidency they will implement strict and costly environmental regulations.   

Investment Strategy

Tariffs, labor costs, and regulations will alter the competitive environment faced by firms.  The impact will vary widely across different industries, and different individual companies. Earnings derivatives make it possible to express a view on profit margins of a single company.  Using options and ETNs linked to BLX Global Indexes, investors can hedge trends in specific metrics over multi year periods.