by Thomas Alonso.
There has been a great deal of discussion regarding profit margins for the S&P 500 reaching record levels recently. In Exhibit 1 below we show net margins for the 11 S&P 500 sectors and the index, showing that most sectors are at or near peaks.
Exhibit 1: S&P 500 Sector and Index Net Margin
Some of the improvement in margins has been driven by the shift in the underlying sectors in the index, with higher margin sectors seeing large increases in their contribution as both their market cap and sales weightings have increased, See Exhibit 2 below.
Exhibit 2: Market Cap Weight in S&P 500 and Net Margin
In Exhibit 3 below we weigh sector margins by their sale contribution to arrive at their overall contribution to the S&P 500 margin.
Exhibit 3: Sector Contribution to Overall Margins
We see a few interesting points in the charts above. First, since 2010 the information technology sector has seen its margin improve about 10 percentage points (ppt.) to 25.5% from 15.3% (Exhibit 1) as these companies likely have benefited from increased scale and likely some pricing power. Further, of the approximately 5 ppt increase in the overall margin for the S&P 500, the info tech sector accounted for about 1.6 ppt (or ~30%) of the entire increase (Exhibit 3).
Second, the volatility in the energy sector is plainly evident with margins falling from a peak of ~8.7% to a low of 0.4% before rebounding to 11.2% in the most recent period. This volatility led energy to move from the 3rd largest contributor to overall margins to the smallest, before rebounding to the middle of the pack in the most recent data.
We believe that one of the under appreciated aspects of the margin improvement we’ve seen over the past 10+ years has been the long-term decline in interest rates.
Using Datastream, in exhibit 4 below, we can estimate the total cost of interest for the largest companies in the US compared the yield on the US 10-year Treasury. Using the mnemonic TOTMKUS, which approximately tracks the largest 1000 companies in the US, we estimate that overall interest expense (yellow line) has fallen even as the level of debt has increased, with the cost of debt (green line) falling recently as well. More importantly for margins, the cost of servicing debt (red line) has been declining since having reached a peak in 2008, and currently stands at 1.88% of sales down more than half from the peak of 3.98%.
Exhibit 4: Cost of Debt and 10-Year Rates
Using Refinitiv Workspace we see similar, if not stronger, trends for the current S&P 500 constituents. While overall interest costs have increased 1.5% since 2010, overall debt levels are up almost 40%, showing how lower rates have helped keep a lid on interest costs. At the same time, sales have increased ~76% over this period, driving the margin impact to 1.65% from 2.86%, a reduction of 121 bps (See Exhibit 5).
Exhibit 5: S&P 500 Companies Interest Costs and Margin Impact
With the 10-year yield having risen ahead of an expected Fed rate hiking cycle and a move from quantitative easing to quantitative tightening, rates are likely to continue to rise and could prove to be a greater headwind for margins in the future as debt comes due and reprices higher.
However, companies in the S&P 500 appear better prepared to deal with a rise in rates as the maturity profile of debt is longer than it was 10 years ago, as we show in Exhibit 6 below. Comparing the maturity breakdown for debt by sector and for the total S&P 500 to 10 years ago, the index has ~10ppt more debt that has a maturity of 6 years or more remaining, 54.9% of the total compared to 44.5% in 2010.
Looking at the table below, we would note that the consumer discretionary sector has the largest percentage of debt due in the next 3 years, at 38.1% of the total for the sector, which could make sector margins more vulnerable to increased rates in the near term. Conversely, the communication services sector has the largest percentage due in 6 years or more, 71.2%, implying the sector could be better insulated from increased rates in the near term.
Exhibit 6: Debt Maturity Breakdown for S&P 500
While there has been much made of pricing power and industry concentration as a driver for increased margins, the decline in interest rates and the impact of the cost of debt has received much less attention. We think investors would be well served to keep on eye on rates and the potential for increased interest costs as we move through this expected rate hiking cycle.
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