Bernard McAlinden: ESN Fundamental Value Monitor
Comment of the Day

July 19 2013

Commentary by David Fuller

Bernard McAlinden: ESN Fundamental Value Monitor

My thanks to the author for this latest fascinating report, published by ESN. It is posted in the Subscriber's Area but here is a brief sample from pages 9 and 10
Earnings have recently been seeing a cyclical recovery as severe recessionary conditions in the global economy have given way to a renewed expansion (albeit erratic and geographically uneven). Underlying structural developments will be key to the extent and sustainability of the earnings recovery as global cyclical conditions continue to improve (albeit erratically).

Over recent years, corporate earnings have benefited from major sustained structural forces. Globalisation, free trade, migration, the opening of China, technology advance, the spread of capitalism, etc have greatly enhanced the supply and productivity of labour on a worldwide basis progressively since around the mid 1990's. The bargaining power of capital relative to labour has therefore seen major sustained improvement and margins / returns on capital have expanded accordingly. These structural forces are currently sustaining US earnings at higher levels than would otherwise be cyclically consistent with a still anaemic economic expansion and are sustaining European earnings at a higher level than would otherwise be cyclically compatible with the ongoing recessionary environment in Europe.

In the established environment of increasingly free and efficient global markets, it is inevitable that market forces would eventually compete margins and returns back down to the long run required levels, whereupon the cyclically neutral level of earnings would structurally revert towards the long run trend line. On the assumption that the forces of globalisation etc are unlikely to go into reverse, it would take ongoing reflation of the global economy to achieve such structural mean reversion. Global final/consumer demand would have to expand to the point where global labour markets tighten sufficiently to allow labour to claw back some pricing power at the expense of capital. Meanwhile, the outlook needs to be bright enough to tempt the global corporate sector to more aggressively chase the supernormal returns on offer by stepping up capital spending to create sufficient new capacity to eventually compromise the pricing power of capital relative to labour. Periods of cyclical economic weakness such as the recent "great recession", when worries focused on the risk of demand deflation, put earnings under significant downward cyclical pressure, but also delay any structural mean reversionary process because they weaken the labour market while restraining investment in new capacity by the corporate sector.

The success of companies in aggressively managing costs and defending margins in the recent recessionary conditions suggests that the structural environment is still quite favourable for earnings with capital maintaining pricing power at the expense of labour. US earnings had recently been recovering surprisingly quickly from their headlong collapse below the 32-year trend line. They are already back well above trend but are now suffering from more recent deceleration in the economy. However, they can yet make new highs if, as we expect, the economy continues its cyclical recovery. European earnings are once again under recessionary pressure due to the Eurozone debt crisis, but will ultimately be governed by the same global structural and cyclical forces that pertain to the US.

In short, we expect that an ongoing (albeit erratic) cyclical expansion in the global economy can yet push earnings to new cyclical highs as there are few signs yet that mean reversionary forces have begun to undermine the structurally favourable environment for profitability. We nonetheless consider it prudent to assume that the structural benefit to margins has peaked and that eventual structural mean reversion of profitability will ultimately create a significant structural headwind for earnings.

David Fuller's view Fullermoney has a high regard for Bernard McAlinden's analysis but I confess to having found the opening section of this report daunting. If some of you do as well, my advice is to stick with it, because the informative graphics commence on page 4 and his subsequent analysis is also very interesting.

Sincerely hoping that I am not misrepresenting, let along appearing to trivialise Bernard's analysis with a brief comment, I was interested to see that it seems to make an academic fundamental case for the choppy market period which Fullermoney suspects we will see over the next few years, as QE programmes are wound down, hopefully without too many frights.

Lastly, from his third paragraph above:

Global final/consumer demand would have to expand to the point where global labour markets tighten sufficiently to allow labour to claw back some pricing power at the expense of capital.

I would not hold my breath waiting for this to happen. Looking beyond the current period of slow global GDP growth, the bigger problem in terms of both white collar and blue collar employment will be the accelerated rate of technological innovation.

Back to top