The principal driver of the strong equity market returns of the past few decades has been the historic expansion of corporate free cash flow (FCF) margins, a trend we believe is under serious threat. Margins soared from 3% in the 1990s to near 15% recently, a period during which U.S. nominal GDP growth slowed by around two percentage points.
Many of the factors that delivered a world of stable growth, low interest rates and ultimately robust margins over this period are reversing, making the current moment a seminal one in equity markets. In this report, we examine the drivers of margin expansion, the outlook for free cash flow margins and the ultimate impact to equity markets.
Executive summary
The end of the Great Moderation
- The Great Moderation, which we can loosely define as the macro regime that presided over much of the 1980s through the 2010s, may be coming to an end. The era has been characterized by slowing economic growth, low macro volatility, long expansions and relentlessly declining interest rates. The factors contributing to this backdrop are numerous—aging demographics, technological change, a more intrepid monetary policy and globalization, to name some of the primary drivers. The Great Moderation has been a boon for traditional assets but has also introduced large problems, both political and economic, that today are helping to drive a shift toward a new macro regime.
- The pertinent questions for investors now relate to interest rates and margins. The recent sharp rise in interest rates—driven by inflation and central banks’ reaction to it—has sent ripples through markets. Profit margins, which sit at record highs, may be pressured by deglobalization, onshoring and higher cost of capital. The reality is that most investor portfolios are long duration and highly weighted toward the sorts of companies that have benefitted most from trends brought on by the Great Moderation, making this a precarious time.
- Capital spending has slumped in developed markets for the better part of two decades. Since the last real spending boom in the late 1990s, the expansion of globalization has allowed firms to offload spending to (cheaper) emerging markets, and technological advancement has produced a battalion of capital-light, ultra-profitable business models. The uninspiring economic climate that developed following the Global Financial Crisis also disincentivized firms to invest in new capacity, and their austerity weighed on labor productivity, feeding the flywheel of sluggish economic growth. The drought in business spending is both a symptom and a cause of the broader macro environment that has been dubbed the Great Moderation.
- Management teams have made an about-face over the past two years as business spending has surged. At the core of this reversal is inflation. Supply chain snags have driven input costs higher and laid bare the fragilities of today’s complex logistics processes. Crucially, inflation has also changed the calculus for companies, pushing up the opportunity cost of pushing off investment. There are long-term forces at play as well, including the energy transition, renewed defense spending, and robotics and automation.
Margin Stall
- The single most important number in equity markets over the past few decades has been the free cash flow (FCF) margin. It currently rests around 14% and has sat above the nominal growth rate of the economy since 2000, making it hugely economically significant. Much of the secular increase in margins can be attributed to declines in interest and tax rates, a falling labor share of income, and lower capital spending—each of which can be traced directly to globalization.
- Based on our margin model and medium-term macro forecasts, we believe FCF margins are likely to decline from their current levels. Even if margins simply stagnate at current levels, the ability for the equity market to grow free cash flow at a persistently faster rate than GDP and corporate revenues has been predicated on continued expansion of margins. It appears to us the well may be nearly dry for the primary drivers of margin expansion, especially for interest and tax rates. Deglobalization threatens to upend the ability for businesses to keep their labor costs and capital spending in check.
- In what we believe will be a new era for investing, free cash flow will be more important than ever. The balance in markets, which oscillates over time between emphasizing cash flow growth and cash flow valuation, will tip back toward the valuation side, as it has begun to do in 2022. The cohort of winners is likely to change in the coming years as some of the companies who have realized the benefits of margin expansion—tech firms and global manufacturers, most prominent among them—are likely to be in the eye of the deglobalization storm. Cycles are likely to be faster and more volatile. While all this may portend lower equity multiples and ultimately lower returns going forward, we believe it will offer a generational advantage for active managers with a deep understanding of FCF production dynamics.
