Rising interest rates are sending jitters through the stock market. It’s little wonder why: Rising rates tamp down demand for goods and services and boost corporate borrowing costs.
But higher rates aren’t necessarily a death knell for stocks. Plenty of research has shown that the U.S. stock market has performed well during periods when the Federal Reserve is hiking rates as long as the Fed doesn’t overshoot and tank the economy. That is a real concern right now, and time will tell whether it is warranted.
What would spell certain disaster for stock prices? Plummeting profit margins.
I’ve spent the past five years studying 150 years’ worth of U.S. stock market history. Among the findings: Over the past 30 years the increase in corporate profit margins has been the single largest driver of the S&P 500. Adjusted for GDP, the S&P 500 market capitalization in December 2021 was 3.9 times its December 1991 level—and 54% of that increase has been due to rising profit margins.
To be sure, the decline in interest rates over the period has also played an important part, accounting for 39% of the rise, with a slew of other factors explaining the remaining 7%. But profit margins are the big Kahuna.
Another of the findings: at the end of 2021, the profit margins of S&P 500 companies were at a 100-year high. This goes a long way toward explaining the market’s strong performance over the past several decades.
The good news is that the largest driver of the increase in profit margins will remain in place. The fate of the other drivers is an open question.
Why have margins risen so sharply? The single biggest factor is the overall improvement in corporate decision-making, which accounts for 40% of the increase in profit margins over the past 30 years, according to the research. The improvement has been multifaceted.
To start with, it used to be common for a significant minority of an S&P 500 company’s business units to be value-destroying; I saw this first-hand as a management consultant in the 1980s. But companies have systematically pruned their operations in recent decades. The result is both increased profitability at the individual company level and increased industry concentration—a natural margin booster for all players.
At the same time, business schools have taught managers to understand that increased sales generated by discounting are not necessarily profitable, and that pricing should be used to maximize profitability rather than sales. Mid-level management incentives have been aligned accordingly. Irrational pricing is less prevalent than it was.
Another improvement: cost discipline. In the late 1970s and early 1980s, S&P 500 companies were not cost-efficient. The combination of foreign competition, corporate raiders, the rise of private equity firms, the rise of low-cost offshoring opportunities, and senior management incentives have gradually changed the picture so that, for many S&P companies, processes are in place to ensure costs expand at a lower rate than revenues, boosting margins over time.
Finally, companies are better at acquisitions. For a long time, many post-merger integrations were dismal failures, which is why academic studies noted that acquisitions benefitted the shareholders of sellers and not the shareholders of acquirers. But the picture has improved. Corporate acquirers have been honing the craft of post-merger integration, and botched deals are rarer than they once were.
These improvements are likely to persist. After all, what has been learned is not about to be unlearned. However, the factors that account for the remaining 60% of the growth in profit margins are potentially less permanent.
First is the emergence of a two-tier market structure. The digital era has created enormous businesses that enjoy network effects and increased returns to scale, particularly in the tech sector. These businesses have had an outsized role in the performance of the S&P 500. It isn’t clear whether the next wave of technological innovation will have the same dynamics.
Second, favorable regulatory conditions have prevailed. The last few presidential administrations have taken the view that the increased concentration in many industries, particularly the digital ones, was largely benign and had more societal benefits than costs. As time goes by, this view could change.
Third, globalization and the decline of labor bargaining power have, taken together, allowed productivity gains to outstrip wage gains, to the benefit of margins. These factors would reverse if deglobalization truly takes hold, labor shortages continue, and union advances become more prevalent.
Fourth, the commodity supercycle has accompanied this period of growth. High points in the cycle correspond to transfers of wealth from commodity-consuming countries to commodity-producing countries. Low points correspond to the opposite. The U.S. economy at large, and the S&P 500 more specifically, have become less sensitive to the supercycle. But an indirect effect remains: A rising commodity cycle disproportionately extracts wealth from the bottom half of earners in the consuming country. History shows that this can have political consequences that are unfavorable both to profit margins and the general welfare of asset owners.
Finally, there’s taxes. The combined corporate and investor personal tax rate declined to 18% in 2021 from 30% in 1991, according to Oliver Wyman research. That, too, has helped boost margins. Of course, society has taken different views at different times as to what the appropriate tax rate should be. Time will tell whether the future will look more like the distant past or the recent past.
So, while rising rates are on everyone’s mind, that is only one of the factors that will determine how equity prices play out in the years ahead. Our modelling shows that the market would fall by about 35% if the nonmanagerial portion of the margin improvement returned to its December 1991 level. The others are variables that companies can’t control—but that investors need to be watching.