(Barclays)

We may have seen the peak in US corporate profits. And what could happen next isn't good.

Since the financial crisis, corporations have managed to deliver robust profit growth by offsetting the drag from weak sales growth with widening profit margins. These fatter profit margins came from cutting costs, which usually means getting more productivity out of fewer workers.

But with the labor market tightening, wages are going up. And that means higher costs and ultimately tighter margins. And this is bad news for earnings.

What's worse: This could be signaling a recession.

"The link between profit margins and recessions is strong," Barclays' Jonathan Glionna writes in a new note to clients. "We analyze the link between profit margins and recessions for the last seven business cycles, dating back to 1973. The results are not encouraging for the economy or the market. In every period except one, a 0.6% decline in margins in 12 months coincided with a recession."

(AP Images)
Warren Buffett

Large profit margins come with all sorts of broad implications. Importantly, a fat margin will welcome competition until prices and then margins correct themselves. And if that doesn't happen, you risk worse things like social unrest.

Warren Buffett spoke about this in 1999 (via Jesse Felder).

In my opinion, you have to be wildly optimistic to believe that corporate profits as a percent of GDP can, for any sustained period, hold much above 6%.

One thing keeping the percentage down will be competition, which is alive and well. In addition, there's a public-policy point: If corporate investors, in aggregate, are going to eat an ever-growing portion of the American economic pie, some other group will have to settle for a smaller portion. That would justifiably raise political problems—and in my view a major reslicing of the pie just isn't going to happen.

(YouTube / Charlie Rose)
Jeremy Grantham

GMO's Jeremy Grantham is arguably the most vocal skeptic of persistently high profit margins (via Advisor Perspectives):

Profit margins are probably the most mean-reverting series in finance, and if profit margins do not mean-revert, then something has gone badly wrong with capitalism.

If high profits do not attract competition, there is something wrong with the system and it is not functioning properly.

So, mean-reversion in profit margins is broadly accepted as a healthy phenomenon in capitalism. And it's likely to do more damage to the stock market than the economy.

While this process is associated with recessions, Glionna notes very clearly that it's also no guarantee. And the one time the economy did dodge a recession as margins contracted — in 1985 — we had conditions similar to today's.

During this period, Glionna writes:

Most importantly, the decline in profit margins was caused by the energy sector. In 1985, profit margins for the energy sector collapsed as oil prices began a 60% plunge. But, outside of the energy sector profit margins were stable. Similarly, the drop in profit margins that has occurred in 2015 is primarily the result of lower margins from the energy sector, once again due to falling oil prices.

Indeed, low energy costs is actually a source of margin expansion for energy-intensive companies and budget relief for penny-pinching consumers.

"Perhaps a decline in profit margins is a less reliable signal for recessions when it is caused by the energy sector because lower oil prices are good for the economy," Glionna said.

(Barclays)

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