In this thematic view, we look at current operating margins and 12-month forward price earnings (P/E) ratios of the constituent sectors of the S&P 500 in the US as of the end of February 2023. The US has, over the last year or so, faced an unusual economic environment which in turn drives the relative performance of listed equities.
The standout economic theme over the last year in the US has been the high levels of inflation that have been experienced as a result of a combination of the fiscal stimulus, which added money to the US monetary system and thus aided the financial conditions of the US consumer; global supply challenges, which affected the relative supply and demand of goods and services with particular impact on shipping costs and subsequently costs of transported goods; the Russia-Ukraine war, which affected food prices globally as Ukraine is a major player in agricultural markets; and elevated oil prices, particularly Brent crude prices. The situation has also been exacerbated by the role Russia plays in the supply of energy to Europe, which fuelled energy prices.
These various challenges have an overall impact on the bottom line of most, if not all, companies. This, therefore, plays into the theme of margin dynamics in the US and the relative attractiveness of investing in specific companies/sectors based on the multiples they may be trading on.
Chart 1, shows how, over the last five months or so, we have seen operating margins contract (fall) across all industries except real estate, energy and utilities.
But, in chart 2, we see the materiality of the margin compression story. Just five months ago, seven US sectors’ operating margins were above the 50% percentile, indicating peak and/or higher than average operating margins seen over the last 10 years or so. The opposite is now true, seven US sectors are now below the 50% percentile. Of the sectors where operating margins were already below the 50% percentile, only utilities have expanded while consumer discretionary, consumer staples and industrials have continued to contract. The notable exceptions are energy, materials and information technology which remain above the 50% percentile. Energy remains at peak operating margins in Q1 2023 as energy prices remain high globally, although energy inflation has started to roll over (come off) in the US.
Chart 2 (click through the arrows for more detail):
From a valuation perspective, as chart 3 shows, the sectors that stand out are information technology (IT), and financials based on their respective operating margins and 12-month forward P/Es relative to history from Q1 2013. Cyclically high margins should come with cyclically low P/Es and that is broadly the case in the US. The most notable exceptions are IT (high multiple and high margins) and Financials (low margins, low P/E).
In terms of the financials sector, the low operating margins for banks are a function of bank asset quality deterioration, driven by the higher levels of inflation and the relative impact on the spending power and disposal incomes of consumers, while insurers are carrying higher cost inflation, driven by the performance of auto-vehicle values which increased exponentially in 2022. As asset prices roll over and inflation is tamed in the US, there is scope for material improvements in the operating margins of the financials sector, which can unlock price earnings value.
The information technology sector appears to be on high valuations relative to its history (from 2013). This sector in particular is not as predisposed to rising interest rates and inflation as the business model is highly cash generative with lower debt levels relative to other sectors. The businesses are susceptible to disruption in the form of advances in technology where some players are left behind (think ChatGPT and the relatively large investments by Microsoft and Chinese firms such as Baidu since the surge in interest in artificial intelligence). An advance in technology can be a catalyst for the major players, but a hindrance for smaller players who can’t keep up. The valuation given this particular tech advance could very well hold up, even as margins come under pressure due to the relative investments required in the field.
And just some food for thought … in the real estate sector, the operating margins are somewhat surprising in the light of the rising interest rate environment in the US and the entrenchment of work-from-home since the pandemic. This Wall Street Journal article link (behind paywall) shows the magnitude of distress among property owners in the US, with several defaulting on their loans and restructuring their debts with lenders. It’s a perfect storm in the US real estate market, with rising lending rates, low occupancy and falling lease renewals. A Redfin report shows similarly that home values deteriorated in 2022, further revealing the relative impact on wealth in the US in the form of distressed consumers. The report showed that in Q2 2022, the US housing market dropped 4.9%, the biggest drop since the 2008 financial crisis.
In summary, the effects of high inflation and rapidly rising interest rates are filtering through the system. Looking at 12-month forward P/Es and operating margins, this is a net negative for the real estate sector and opportunities may exist for the financials sector as inflation rolls over and interest rates peak. The information technology sector has multiple variables at play which could impact margins and high valuations. It’s a space we are watching with interest.
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