For the majority of this century, economic growth and corporate profit margins moved in tandem with one another. A look at the chart below shows how tight the relationship between the two variables have been. It’s historically been a dead heat. However, beginning last year, the variables have begun to diverge with S&P500 Operating Margins on an upward trend and US Nominal GDP growth declining.

Some investors have been hesitant to invest and often cite economic concerns. These concerns are well founded as we hear reports of slower labour growth, fewer job openings, declining wage growth, decreased manufacturing activity and reduced capital equipment investment. These headlines have been loud and frequent. Unfortunately, taking cues from the economy has led investors to miss out on great investment returns. Despite the softer economic data, the market’s patience and runway for the economy has been extended as GDP and the consumer remains resilient. A mostly well-behaved inflation and unemployment landscape combined with interest rate cuts has also helped contain investor nervousness.

It appears that the market is paying attention to a different horse in the race. Profitability and margins seem to be what investors are focusing on. As margins rise, profitability increases and this helps expand the multiple of what investors are willing to pay for stocks. This increase in margins can be attributed to a number of factors. First, the equity market’s sector composition is increasingly made up of technology, financials and other service based businesses that enjoy above average margins.  Moreover, companies across all sectors are benefitting from digital transformation and scale efficiencies, while their pricing power has been retained due to their strong brands, unique products and technological innovation. Finally, cost management has also improved with slower wage growth and improved automation. In all, this is the horse that we think investors should take their cues from in the long term.

Further weakening of the economy will eventually impact margins. Profits and the economy do not operate in a vacuum of one another; they are interconnected. However, for the time being, the improvement and sustainability of margins is a more powerful narrative for the market, and should this continue, it should justify the buying of any near term market pullbacks.