US central bankers hope lower profit margins will aid inflation fight

Profit margins are sliding across much of corporate America as companies struggle to keep raising prices, cheering central bankers trying to fight soaring inflation but frustrating investors seeking higher returns.

Pre-tax profits for S&P 500 companies hit an all-time high in the second quarter of this year, US Bureau of Economic Analysis data show. They have surged almost 70 per cent since the same period in 2020, fuelled by government stimulus payments designed to boost the spending power of consumers and businesses when Covid-19 hammered the global economy.

Wall Street’s estimated net profit margin for the index this quarter has fallen to just 11.6 per cent, however, according to FactSet. That would be down from 11.9 per cent in the third quarter, and from 12.4 per cent in the final three months of last year, to the lowest level since the end of 2020.

Analysts have been cutting their earnings forecasts for 2023 and now expect a further decline. BMO Capital Markets recently predicted a contraction of about 5 per cent from this year and some strategists have floated the possibility of an “earnings recession”.

The Federal Reserve’s second-in-command, vice-chair Lael Brainard, has said bringing down “elevated” retail margins — the difference between what an item costs a retailer and what a consumer pays — would help alleviate the price pressures that have forced the central bank to ratchet up interest rates.

Services-related inflation, including costs related to dining out, travelling and medical care, remains high and by most estimates is likely to keep price pressures elevated through to at least the end of next year.

But recent data suggest broader inflation might have already peaked, with gains in other sectors offset by the declining costs of energy and everyday items such as clothing, furniture and household appliances.

Brian Belski, BMO’s chief investment strategist, said it would take “profit margin deterioration” to ultimately bring down consumers’ inflation expectations and persuade the Fed to ease up on tightening.

For more than two years, most businesses have responded to the rising costs of supplies, logistics and labour by increasing prices. In an earnings announcement in December, for example, cereal maker General Mills noted that it had managed to raise prices by 17 per cent to offset a 6 per cent fall in volumes.

Bob Gamgort, chief executive officer of Keurig Dr Pepper, similarly told a recent Bank of America event that despite the soft drinks industry’s “aggressive” price increases to protect margins, “consumer elasticities have held up really, really well”.

But executives at other companies are cautioning that their ability to keep raising prices may be reaching a limit. Nike recently reported that it needed to mark down some prices, eroding its margins.

Consumer goods giant Procter & Gamble expected to strike a new balance between price and volume growth over the next 12 to 18 months, chief financial officer Andre Schulten told a Morgan Stanley conference this month, because “purely price-driven growth is not going to be sustainable”.

Most Fed officials expect their preferred inflation gauge, the core personal consumption expenditures index, to decline to 3.5 per cent by the end of 2023, down from the 4.8 per cent level forecast for the end of 2022.

Ian Shepherdson, chief US economist at Pantheon Macroeconomics, expects inflation to fall much more than that, however, not least because the Fed “underestimates the extent of the disinflationary forces already at work in the economy”.

Rather, he expects core PCE inflation to decline below 2 per cent on a year-over-year basis in the second half of 2023, in large part because he expects profit margins to contract rapidly.

Complicating the outlook is the fact that many economists expect a US recession next year as the Fed advances its most aggressive campaign to raise interest rates in decades. As of mid-December, most officials expect the US central bank’s benchmark rate to peak above 5 per cent next year, up from the current target range of 4.25 to 4.50 per cent.

Against a weaker economic backdrop, Tom Porcelli, chief US economist at RBC Capital Markets, warned that companies would try to protect their profit margins by “going after labour”, suggesting more job losses than the Fed expects.

According to officials’ most recent projections, the median estimate for the unemployment rate is 4.6 per cent, nearly 1 percentage point higher than the current level.

“As you face margin compression and you try to defend against that, you’re reducing overtime, you’re freezing wages, freezing hiring or even outright lay-offs,” said Carl Riccadonna, chief US economist at BNP Paribas, citing recent cuts across the technology sector.

“We’re seeing glimpses of what 2023 could look like: a year of margin compression and lay-offs and pullback and caution,” he said. “If we’re all thrifty at the same time, we’ve pushed ourselves into a recession.”