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Corporate profits, stocks face 'a major turning point': Bridgewater

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Gregory 'Greg' Jensen, co-chief executive officer of Bridgewater Associates, pauses during a Bloomberg Television interview on day three of the World Economic Forum (WEF) in Davos, Switzerland, on Friday, Jan. 23, 2015. World leaders, influential executives, bankers and policy makers attend the 45th annual meeting of the World Economic Forum in Davos from Jan. 21-24. Photographer: Simon Dawson/Bloomberg via Getty Images
Gregory 'Greg' Jensen, co-CIO of Bridgewater Associates. Photographer: Simon Dawson/Bloomberg via Getty Images

Some of the forces that have propped up U.S. corporate profit margins — a significant driver of stock market returns over the last two decades — face a major test as global trends shift, Bridgewater Associates said on Wednesday.

In new research, Bridgewater Associates, the $160 billion hedge fund behemoth, argued that global economic trends that have boosted profits “are unlikely to continue being supports, and some are likely reverting," co-CIO Greg Jensen and his team wrote in one of two papers made public.

"We think there is a decent chance that we are at a major turning point for corporate margins, and if that is correct, U.S. equities have a major valuation problem," the authors warned.

In what Bridgewater described as the most "pro-corporate environment in history" over the last 20 years, multinational corporations have largely benefitted from macro trends like "decline in labor's bargaining power, increased globalization, lower anti-trust enforcement, technology allowing for greater scale and lower marginal costs, and lower corporate taxes, interest rates, and tariffs."

To be sure, China was the "major exception," Bridgewater’s analysis noted, as profit margins in the world’s second largest economy fell due to rising labor costs driven by Western demand.

‘Highly overvalued’

In spite of widespread recession fears and a whipsaw market, the Dow (^DJI) is within shouting distance of new record highs— which could come sooner rather than later if this week’s rally continues.

However, Bridgewater explained that without those consistent expanding profit margins seen over the last 25 years, U.S. stocks would actually be 40% lower today.

The analysis stated that it could be hard to maintain the current level of profitability, and increase profit margins in the years to come.

That is because some of the factors helping corporate profits have big question marks going forward, the firm said. Threats to the current scenario include the decreased incentive to move production offshore as labor costs equalize; meanwhile, domestic labor costs and trade conflict increase the likelihood of offshoring.

Elsewhere, the benefit of tax arbitrage by moving abroad is under threat— especially as Europe's proposes a "digital services tax" meant to end the practice, Bridgewater noted.

What's more, the market currently expects more profit margin gains going forward, but that might not happen.

"The long-term valuation of equities hinges heavily on what happens to margins going forward,” the hedge fund’s report said.

“If margin gains can be extrapolated, then valuations look reasonable; if margins stagnate, then valuations are a bit expensive but not terrible,” it said. However, “if margins revert toward historical averages, then equities are highly overvalued," Bridgewater added.

The populist effect

Moreover, as populism rises, protectionist sentiment and rising animosity toward globalization—and multinational companies—is becoming more powerful.

Those trends have sparked "more welcoming attitudes" toward government regulations, including talks of taxing and regulating "superstar tech firms," especially in Europe, Bridgewater noted.

"While there is no precision to when and how much each of the factors described above will weigh on profit margins and how much can be offset (for example by automation picking up), it will be hard for companies to maintain the current level of profitability over the coming decade, let alone increase the margins further from here,” they conclude.

Julia La Roche is a finance reporter at Yahoo Finance. Follow her on Twitter. Send tips to laroche@oath.com.