As we enter the second half of 2012, the markets will start to look forward and discount slower American growth, which would be negative for stock prices.
Ben Inker, the head of asset allocation at GMO, essentially voiced the similar concerns over potential margin compression as the effects of fiscal drag become more evident next year:
High profit margins are the biggest impediment to returns in the equity markets. "The big issue is profits are at an all-time high relative to GDP," Inker said. "We don't think that is sustainable. We think it's going to come down."
The question is, why has that occurred amid a relatively weak global economy? And what could cause it to change?
Inker believes the reversal of government budget deficits will kill margins. Profits have risen as corporations have successfully cut labor costs, but that was a short-term gain, Inker said. Normally, wage reductions and workforce cutbacks leave less money for consumers to spend across the whole economy. That didn't happen over the last several years because the government stepped in with offsetting stimulus measures, allowing disposable income to remain high despite the fact that labor income has been shrinking.
Hence current profits cannot last for long. Even though he expects modest growth in the global economy, lower unemployment and higher capacity utilization, Inker said that "as a necessary condition of decent growth, we need to see profit margins come down."
Today, US equities are the market leader based on a belief of an improving consumer (see
This bull depends on the US consumer), Europe is starting to go sideways on concerns over Spain, Portugal, etc., and China is not showing strength.
My
Asset Inflation-Deflation Trend Model moved to a neutral reading early last week (see
Time to take some risk off the table), which is the likely correct tactical response for now as the markets aren't in any imminent danger of tanking dramatically. Looking forward, however, the 12-month outlook for the US are faltering. There are a number of China bulls starting to come out of the woodwork (see example
here), but I can see no technical turnaround in Chinese related markets for the moment.
Under these circumstances, the bulls only hope are dependent on a revival of Chinese growth in the 2H, which is a risky bet on timing. While my inner trader isn't outright bearish, my inner investor tells me that selling in May is starting to sound good right now.
Cam Hui is a portfolio manager at Qwest Investment Fund Management Ltd. ("Qwest"). This article is prepared by Mr. Hui as an outside business activity. As such, Qwest does not review or approve materials presented herein. The opinions and any recommendations expressed in this blog are those of the author and do not reflect the opinions or recommendations of Qwest. None of the information or opinions expressed in this blog constitutes a solicitation for the purchase or sale of any security or other instrument. Nothing in this article constitutes investment advice and any recommendations that may be contained herein have not been based upon a consideration of the investment objectives, financial situation or particular needs of any specific recipient. Any purchase or sale activity in any securities or other instrument should be based upon your own analysis and conclusions. Past performance is not indicative of future results. Either Qwest or Mr. Hui may hold or control long or short positions in the securities or instruments mentioned. 
