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It isn’t just US large-cap companies hanging on to near-record profitability. It’s happening worldwide.
Even outside the US, developed markets’ corporate profit margins have steadily climbed in the past few decades, according to a JPMorgan note this week:
Nb: It’s tough to directly compare profitability between the two categories in the chart above. JPM calculates US companies’ margins using national accounts data — which is a neat way to make a long-term comparison across the entire US economy — and uses a more straightforward calculation of the MSCI Index’s profits vs revenues for other developed markets.
Regardless, profitability is still close to historic highs. That’s a pretty notable trend given the pick-up in inflation that could (or should?) have threatened it. From JPM:
Where [profit margins] go in the coming year will have an important influence on the health of the expansion. Pricing power is fading as inflation falls but wage inflation is also moderating. Unit labor costs are being tempered by a pickup in productivity in the US. Looking forward, we see a race between wages, productivity, and prices, with the latter a key input into central bank easing cycles.
The soft-landing scenario requires resilient growth and slowing inflation sufficient to warrant policy rate cuts.
The bank is pretty evenly split on the probability of a soft landing or a recession by mid-2025. And if a recession is on the way, it could show up early in corporate profit margins that fall too low — or climb too high.
JPMorgan sees two ways this could happen:
1) A profit-led recession (“Wait for it”): As profit margins get squeezed, businesses begin to worry about their overall earnings. With profits under threat, businesses pullback on hiring and fixed investment. This is the spark that starts the next recession. History has shown that margin compression leads recessions. While the timing can be extended (eg, the mid-1980s, mid-1990s, and the post-GFC expansion), the peak always comes before the downturn.
2) Pricing-power prevails (“Too darn hot”): Businesses do not need to cut costs in the face of margin compression. Instead, they could respond by raising prices. If this were to happen, margins would rebound. With labor markets still strong, household spending would continue to expand. The combination of strengthening revenues with rising margins would bolster profits, fueling nominal growth. However, central banks will not sit by and let inflation run well-above targets. In this scenario, we envision the Fed and other central banks staying high for much longer or even hiking further — eventually forcing a recession.
The US hasn’t really experienced “too darn hot” inflation driven by corporate pricing power (scenario #2 above) in decades, at least. But Covid-19 may have been a turning point for corporate pricing power, the bank says, so the risk could be higher now:
In the “too darn hot” scenario, the implicit assumption is that businesses maintain pricing power in a way that was not evident in the last expansion when inflation was confoundingly low. What might have changed to make this scenario possible? One argument is that the threat of losing market share pre-pandemic kept pricing power in check. This changed with the pandemic. Acting as a coordinating event (and noise generator), the pandemic led all businesses to raise prices together — thereby removing the threat from lost market share. Whether this period of coordinated price increases fades is a central question for central banks and for the duration of the expansion.
Greedflation? Excuseflation? Whatever you call it, it could be pretty important as we wait for “sticky” services inflation and higher interest rates to echo through the financial system and economy.
Further reading:
— US companies are still very profitable
Source: Economy - ft.com
