What to expect from profitability of US companies?

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It is probably agreed that the profitability of US companies is very strong in relative terms and that this has helped suck capital into the US. Since the depths of the global financial crisis in 2009, overseas investors have doubled the value of US equities that they hold according to Fed data– although that has slipped in recent quarters as the equity market has fallen.

It is easy to see why US equities have been a big draw for many years. The profitability of firms continues to rise strongly and, most noticeably, this has continued recently despite the fact that soaring costs might have been expected to put pressure on margins.

So far, there has not been the dip in margins that accompanies a sharp slowdown in growth (don’t forget that the US economy has not grown so far this year). That could– and probably will – come in time but, for now at least, US firms still seem to be sitting relatively pretty and overseas investors who have bought US stocks this year without currency hedges have generally found that they have done much better than they would have done had they kept cash in the domestic market.

In all, we’d argue that the equity market is a place that has supported the bullish argument for the dollar. Of course, this can come at a cost of end-month and end-quarter dollar weakness as index trackers reduce their holdings of the better performing stock markets to maintain desired geographical proportions.

But, by and large, this is small beer in Mr. Steve Barrow, Head of Standard Bank G10 Strategy’s view, and he has little doubt that the stock market is a positive for the dollar not a negative. A slide in US stocks, such as that we’ve seen this year, can be “compensated” by dollar strength as the “risk-off” environment lends itself to a stronger greenback.

As a result, we might even argue that both US stock market strength and weakness can benefit foreign holders. But it is unlikely that the US can have it all ways. For one thing, we have to ask why US profitability does tend to hold up so well and, for many, that’s down to a lack of competition.

When we look across many products and services, we find that the US comes out poorly. Take broadband; something that might appear pretty ubiquitous when it comes to customer access, pricing, and more, at least amongst advanced countries. But the last time the OECD looked at this, US consumers were generally paying twice as much for broadband access as their German counterparts, and 50% more than UK consumers. This is not an isolated instance. The notion that the US is the most competitive nation around seemed to be discredited a long time ago and you can see this in how US legislators have tried to reduce pricing power of large firms in areas such as prescription drugs.

Why might this matter now? Mr. Steve Barrow thinks it does because inflation data and profit margin data could be creating a toxic mix of persistent price pressure as firms are simply able to better pass on cost increases to their consumers than most other places in the world. This threatens to make the current rise in inflation far “stickier” than we see elsewhere, putting the Fed in the unenviable position of either allowing high price growth, or going extra hard with rate hikes to provoke the depth of recession that might just make pricing a bit more sensitive to demand. Of course, the latter path could provoke much deeper risk-off mentality amongst investors and a stronger dollar, but Mr. Steve Barrow does not believe that it will be the path that the Fed chooses.