Profit margins in the US are at historically high levels, and have accounted for 80 per cent of earnings growth over the past three years. Paolini (pictured) says this is unsustainable for the same reason that declining profitability is a global problem: companies are coming under pressure from rising labour costs and tax-hungry governments.
"Margins are effectively a measure of the profitability of the corporate sector and are affected by taxation and wage growth, and we have seen the best combination over the past few years: wage growth has been weak and taxation being cut," he said.
"But the problem is that governments need money, householders are highly taxed and while corporate gains are high, governments will look to get some more money out of corporates."
Pictet projects annualised returns of 3 per cent over the next five years for the US market in dollar terms, which is well below the long-term average and the returns of the last three years.
Performance of indices over 3yrs
Source: FE Analytics
The group’s projection for the UK market over the same period is 5.8 per cent.
The US and UK governments, as well as those of other developed countries, have been putting multinationals under pressure to pay more tax, with many avoidance schemes being criticised by authorities and electorates alike.
The G20 recently agreed to limit loopholes that allow multinational companies to reduce their tax obligations.
This pressure represents the reversal of a 50-year trend of increasingly favourable tax rates, the strategist says.
Paolini adds that the pressure is likely to increase, and Pictet’s equity analysts are already factoring in declining margins into their stock assessments.
The second major pressure is the increase in wage costs.
Margins tend to move in the opposite direction to wages, which are the largest cost that companies have.
Real wage growth has been negative almost everywhere, Paolini claims, and this is set to reverse.
One of the major reasons for this on a global scale is declining demographics in China.
"We have seen a massive increase in global labour force in China, which is now slowing," Paolini said. "The slowdown in the labour force pushes up the price of labour."
Paolini points out that equities already look expensive in historic terms. Pictet’s valuation model suggests that the S&P 500, at 11 to 12x future earnings, is 20 per cent overvalued from where it should be.
"Bond yields are low but equities are not cheap against their average of the last 100 years, so do not expect a big re-rating in equities," he said.
Miton’s James Sullivan recently told FE Trustnet that he would want to see a fall of 25 per cent in the UK market before he would see valuations as attractive, and that he was steering clear of equities on that basis.
However, Paolini thinks that the poor level of returns available elsewhere and the effects of QE mean that even at current valuations, buying stocks makes sense.
The strategist says he expects margins to fall on all major markets except one.
"The exception is Japan, where margins are already very low and their reforms mean they will converge to margins in continental Europe at least," he explained.
"Earnings growth will be lower than GDP growth, whereas the opposite has been the case for many years," he added.
Companies have been slashing costs and looking to increase efficiency over the past few years, and Paolini says they will have to continue.
"The big question is productivity. How much can corporates push profits up?" he asked.
"There’s a limit to how much productivity growth you can have, so will companies be able to generate big productivity gains to offset these negative factors?"
Nevertheless, the strategist says that investors will need to keep a high level of equity exposure if they are going to beat inflation.
"Weak growth and rising interest rates isn’t a good combination for equity markets, but what are the alternatives to equities?"
The strategist says that a portfolio split 50/50 between bonds and equities is likely to make 0.9 per cent per annum over the next five years, according to the projections carried out by Pictet of returns on different asset classes.
The way to improve on that is to increase the exposure to emerging market equities and reduce exposure to bonds.
The asset manager’s projections suggest annualised returns of 12 per cent on emerging Asian equities, 10.9 per cent on emerging market equities and 8.5 per cent on Latin American stocks.
Inflation is going to be the key threat to investors, with Pictet projecting a figure of 3 per cent per annum in the UK.
"The only real option [for governments] at the moment is to allow inflation to go up to decrease debt," Paolini said.
"But inflation will impact real wages. We still believe that inflation is the easiest way out, the most rational way out for governments from this kind of debt problem."
FE Trustnet recently looked in detail at funds that can protect investors from inflation.
Paolini says that emerging markets are the best bet, as they are likely to be less affected by inflation and to have the strongest currencies – after the Swiss franc – over the next five years.
This should give an extra boost to investment gains made by UK investors.
