April 24, 2023Scroll down
After a pandemic profitability boom, margins squeezed
With Q1 earnings coming into focus, one of the things we’re watching closely is the continued compression of companies’ margins, as a year’s worth of Fed tightening and persistent inflation take their toll. During the pandemic, US firms massively jacked up prices: far more than was necessary to cover increased labor and material costs resulting from COVID-related disruptions. The result was a correspondingly massive increase in corporate profits, with margin growth rates exceeding both unit labor and nonlabor costs. This can be seen in a plot of gross operating margins for S&P 500 firms, which surged throughout 2021 (see below). One also observes a turning point at the beginning of 2022, as rising costs crept into the calculation. More recently, we have witnessed signs of households tightening budgets, making it harder for companies to pass inflation on to consumers, further squeezing profits.
Analysts coming to terms with reversion to pre-pandemic profits
As we have been warning since macro stresses began to mount in early 2022, it was only a matter of time before analysts baked inflation and the impact of Fed policy into forecasts. It took a while—and we must admit the US economy proved more robust than we expected was possible—but the inevitable effects of these factors continue hitting earnings estimates for the S&P 500, with most of the disappointment coming from lower profitability in sectors such as finance (shaken by banking woes), technology, consumer goods, and communication services. As revenue growth falls short of expectations, the rate of decline in analyst sentiment is likely to increase significantly in the next few months. Ultimately, we believe margins should revert to pre-pandemic levels, although timing that is tough. Abnormal margins can go on for years after shocks like those we’ve experienced since the pandemic began.
Compression in margins could be a gradual process
Of fundamental interest to analysts hoping for a timeline on margin compression is the means by which companies have kept margins this high amidst aggressive Fed tightening. It’s pretty clear that loose monetary policy in the wake of the Global Financial Crisis played a big role in pushing profitability so high, as the Fed’s expanding balance sheet fueled lower borrowing costs, which prompted a surge in gross margins—calculated before deducting interest expense—since 2009, as seen in the chart below.
With rates increasing at a pace not seen since the early ’80s, the days of super-cheap money are long gone and debt costs are rising. While a recent decline in inflation as seen in the last CPI print could help us to sooner reach a pause in hikes, it also indicates waning demand. Unfortunately for many businesses, inflation seems to have been a net positive in terms of profitability, boosting both revenue growth and increasing costs, but lifting the former faster. Given our view that inflation is likely to recede gradually as opposed to suddenly jolting back down to the Fed’s 2% target, slower sales growth leading to an erosion in margins could be a drawn out affair. Other explanations for high margins, including underinvestment to boost short-term profits at the expense of longer-term growth, as well as labor market dynamics currently favoring employers, also suggest a gradual rather than abrupt decline in margins. Of course, even a ‘slow burn’ retracement in corporate profits doesn’t mean markets need to wait to price it in—it’s just unlikely to happen before investors accept the next decade might not be quite as rosy as the last one for US companies’ bottom line.
Weakening USD will be a boost to some markets
Through 2021 and most of 2022, the US dollar staged an amazing rally, posting trough-to-peak appreciation of over 25% during that period. The greenback’s strength was driven by an almost perfect storm of factors, including a global energy crisis, the Fed’s rate hiking spree, and geopolitical risk in Europe. Beginning in Q4 of last year, however, diminishing fears over a global hard landing dealt a blow to the dollar, which is seen as a safe haven in times of economic stress. More importantly, the expectation that the US central bank is nearing a pause and even likely to cut rates by the end of 2023—though we beg to differ on the latter point—has weakened the case to park money in USD to take advantage of higher US interest rates. Indeed, after peaking at the end of September, this waning sentiment has driven the dollar index to its lowest level in almost 12 months, sending European stocks to outperformance versus US shares (see below). We note that dollar weakness would be a big positive for EM, which benefits from dollar declines through relief on their USD-denominated debt, as well as better prices on commodities settled in USD (which tends to favor those emerging economies that are net exporters of resources).
How low can the greenback go?
The question, naturally, is whether the dollar’s downturn is sustainable or merely a bout of mean reversion. We continue to see the dollar as facing a number of medium-term headwinds, not least of which is the approach of peak Fed policy rates, which we wrote about back in January. That said, as long as the dollar’s retreat is being driven by tighter rate differentials and a risk-on sentiment that diminishes the currency’s appeal as a shelter from the storm, we also have the sense that the last two quarters’ sharp drawdown in the dollar will likely moderate and a number of global risks—ranging from escalating geopolitical tensions to an economic downturn we don’t believe has yet been priced—could well trigger occasional flashes of dollar strength. In such an environment, we take comfort in advocating a diversified approach, which includes spreading one’s bets at the level of currency exposure to smooth what we imagine will be a bumpy ride for the greenback in 2023.
China posts better-than-expected growth in Q1
After enduring one of its weakest years of growth in decades due to large-scale lockdowns in its major cities and slowing demand for its exports in the face of a global economic slowdown, China delivered a strong first quarter to begin 2023. GDP growth of 4.5% YoY exceeded economists’ expectations and marked a big increase from the meager 2.9% reported in 2022 Q4. In large part, the upside surprise was driven by retail sales, which grew 10.6% in March, exceeding analysts’ forecasts of 7.5%, though it was notable that infrastructure growth—China’s typical recipe for stimulating its economy out of a downturn—shows signs of slowing. Real estate data were overall mixed in Q1, while muted manufacturing and private fixed asset investment growth largely reflected uncertainty around global demand.
Retail rebounds after lockdown lows
It’s probably not a surprise that in the first full quarter of results after China’s December abandonment of zero-COVID policies, the retail sector was among those posting the strongest rebounds. Retailers suffered most under last year’s lockdowns, which contributes, for one thing, to a very low base for year-over-year comparisons. But there has also been an expectation that pent-up consumer demand and a hoard of pandemic-era household savings would eventually be unleashed in the sector. It’s possible we saw the beginnings of that in Q1. Auto sales, restaurants, and apparel surged back in March, while housing-related durable goods such as furniture and home appliances sales remained weak. While increased household spending is a good sign, we believe consumption momentum is heavily dependent on improvements in labor market conditions and the strength of the broader economy—both of which will give consumers the confidence to keep spending and make bigger purchases that boost categories yet to bounce back. In March, the overall urban survey unemployment rate declined slightly by 0.3% to 5.3%, but the youth unemployment rate stayed elevated while a new batch of graduates will start looking for jobs in June.
Property gloom still in the forecast
As sluggish sales of home-related durables suggests, part of China’s economic recovery relates less to COVID and more to a reversal of China’s property market deleveraging initiative, which authorities began to relax at the end of last year. Those policies, initiated in 2020, put immense stress on the domestic property market, weakening a critical pillar of the Chinese economy. Despite meaningful announcements of support for the real estate sector beginning in November 2022, the effects of a liquidity crisis among China’s property developers continued to reverberate through last quarter’s macro data, with Q1 real estate investment declining by 5.9% and new housing starts plunging 19.2% on a YoY basis. On the bright side, new long-term residential loans grew significantly for the quarter, confirming that the demand for housing continues to recover amidst expanding credit, also a result of policy stimulus. These green shoots, however, haven’t yet been enough to restore confidence in the industry, and policymakers have been reluctant to completely reverse course on restrictive measures intended to improve developers’ balance sheets and reduce real estate speculation—along with the dire effects that has on housing affordability.
Industrial and export expanded
Industrial production increased by 3.9% YoY in March, higher than the 2.4% gain seen year-to-date through February, but short of expectations, reflecting a worsening global demand environment. By the same token, manufacturing investment growth decelerated to 6.2% in March from 8.1% in December. More positive signs on Chinese manufacturing come from alternative data, which show logistics activity in March increasing by about 40% compared to the average in January and February. One of the biggest surprises in China’s recent macro releases was a 14.8% jump in March exports, whomping market expectations of a 5% decline. Much of that growth was driven by electric vehicle sales and exports to Russia and Southeast Asia. We suspect that part of the beat rests on a release of backlogged orders, a holdover from supply chain stresses of the last year that probably won’t persist. Likewise, it seems a foregone conclusion that further lagged impact of rising rates and the uncertainty triggered by March turmoil in the banking sector will hit US and European demand for exports—though a gradual recovery in Chinese manufacturing would be just what the doctor ordered to further ease Western inflation.