A frenemy is an oxymoron, one who is simultaneously friend and foe. Frenemies are worse than enemies because their betrayal catches us when we are least prepared.
For investors, corporate profits are always their best friend. Until, well, they’re not. Now may be one of those times when profits turn from friend to frenemy.
Corporate profits will be in focus over the next several weeks as the first quarter earnings season kicks off. This week, large US banks lead the way. Their earnings are expected to be down on account of a flatter yield curve, higher wage costs, and a higher provisions for wobbly loans.
But this week’s bank earnings, whether better or worse than expected, aren’t the main event. Rather, what investors ought to focus on throughout the earnings season and over the remainder of this year is non-financial corporate profit margins. That is where a ‘heads I win, tails you lose’ aspect resides. As we’ll see, if corporate profit margins hold up, investors lose. If they contract, investors lose. Profit margins are the arriving frenemy.
To understand why margins may become double-edged, it is important to consider the macroeconomic backdrop, which sets the scene for growth, inflation, monetary policy, and risk premiums.
The contours of the economy are by now well known. Over the past 18 months, a combination of massive fiscal stimulus and pent-up demand have led to a surge in spending. Meanwhile, supply-side flexibility has been impaired by pandemic disruptions to production, distribution, and labor. Excess demand has boosted prices and wages, resulting in the highest rates of inflation seen in four decades. Russia’s invasion of Ukraine has only exacerbated price pressures, given war and sanctions disruptions to energy, food, and industrial metals exports from both countries.
What is less well appreciated, however, is the coming slowdown. Falling real household incomes (as price jumps outstrip higher wages), fiscal headwinds (as last year’s stimulus is not repeated) and ebbing consumer spending (as the post-pandemic spending surge fades) will slow demand growth even before the Federal Reserve and other central banks slam on the monetary brakes.
And make no mistake about it, the Fed is planning to slam on the brakes. That is the unambiguous message coming from all Federal Open Market Committee (FOMC) members, hawks as well as doves. The point was driven home by Lael Brainard, formerly a Fed dove, whose aggressive tightening comments last week resulted in a sharp bond market sell-off. Irrespective of whether monetary policy was responsible for surging inflation or not (we think not), the Fed has concluded that the restoration of price stability takes precedent over the achievement of maximum employment. The dual mandate has been suspended and all that matters now is bringing down inflation.
That matters a lot for corporate profits. As night follows day, corporate profits growth follows real GDP growth. Since the data were first collected in the late 1940s, every US economic recession has been accompanied by falling corporate profits. But profits recessions—falling year-on-year corporate earnings—are even more common than economic recessions. Since World War II the US has experienced a dozen economic recessions and twenty profits recessions. In each of the eight non-recession instances of falling corporate earnings, a slowdown in real GDP accompanied the profits slump.
The reason is that profit margins are highly cyclical. A good proxy for aggregate margins is the share of profits in GDP, which captures how earnings fluctuate with total sales. And macroeconomic performance is decisive for aggregate margins. When growth slows sharply or the economy slips into recession, the share of profits in GDP always plunges. Moreover, the pinch on margins this time will be compounded by rising wages, energy, and other input costs.
So, profits are set to slow. Indeed, we think that by year-end 2022 an outright decline in earnings is now likely.
Not so fast, claim the analysts who are paid to dissect corporate earnings. They note, quite rightly, that profit share in GDP is near record highs. At 11.3% of GDP for the fourth quarter of 2021 (most recent observation), the share of profits in total output is just below its postwar record high of 11.8% set in mid-2021 and well above its long-term average of 7.1%. Those same analysts note that even during the 2020 pandemic min-recession, profit share only dipped to 8%, its best recession performance in 75 years.
In short, the consensus of company analysts, which still forecasts upper-single digits profits growth for all of 2022, claims ‘this time is different’.
In several respects, their claim has merit. Profits of large information technology companies, which are so large they skew the overall data, are less cyclical than most. Many tech companies, after all, command super-normal profits given their market dominant positions. Also, energy and materials companies are apt to report very strong earnings based on soaring crude oil, natural gas, and other commodity prices.
But analysts and equity strategists, who are chronically over-optimistic, risk mistaking the few for the many. In doing so, they risk a fallacy of composition—what is true for some is not true for the group as a whole—in this instance for the broad set of companies that make up major equity indices.
The crux of this issue is that if, as most analysts appear to believe, the average listed company can defend corporate profit margins via pricing power—an ability to pass along higher input costs to customers in the form of higher output prices—it must follow that inflation will be more persistent. That further implies that the Federal Reserve (and other central banks) will redouble their efforts to slow inflation by pushing the economy below its trend growth, if not into outright recession.
The bottom line (excuse the pun) is that profit margins are in a vise. Central banks are determined to slow growth, which always shrinks margins. Simultaneously, higher input costs will eat away at profitability.
Overly optimistic analysts and strategists want us to believe that margins will hold up because of pricing power. But because that makes for more persistent inflation, pricing power is an invitation to an even harder landing—for the economy and corporate earnings.
Fat corporate profit margins are typically an investor’s best friend. But that’s not true today. Investors should view margins as a frenemy, often helpful, but occasionally harmful. Today, is one of those cases where investors might wish for margins to fall. As bad as that may be, the alternative could be worse.