Margins are still too high

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Good morning. All red-blooded Americans hate ties, so we at Unhedged refuse to see the US soccer team’s draw with mighty England as a moral victory. Other than that, it’s been a great World Cup so far, a welcome distraction at the end of a dreary year for markets. We anticipate a big rally after the US wins the whole thing. Email us: robert.armstrong & ethan.wu.

Margins are still too high

We don’t talk about the producer price index as often as its consumer-focused cousin. But as inflation starts to fall, here’s a chart we’ve been watching curiously:

The pink line above excludes the price impact of retailer and wholesaler trade services. Say you’re Walmart. You buy a bunch of stuff in bulk, unpack it, dust it off and arrange it pleasantly on your shelves for customers to peruse. You haven’t altered the product at all; rather you’re in the business of making buying stuff nice and easy. In exchange for your time and effort, you mark up the price. That mark-up is the value of trade services in the PPI index.

Trade services, in other words, measure gross margins of retailers and wholesalers, which have exploded in the past two years. The basic story here is that a combination of broken supply chains, rising input costs and high demand created pricing power for producers, who raised mark-ups. Those mark-ups, visible in the widening gap above, are fuelling inflation.

This dynamic has not gone unnoticed. Here’s Fed vice-chair Lael Brainard earlier this month:

The data is not comprehensive, but certainly in the retail sector, you can look at retail margins, relative to how much wages have been growing in that retail activity. And you can look at that mark-up, and how it compares with inventory-to-sales ratios.

So normally, as inventory-to-sales ratios increase, you’d actually expect more competitive pressure to start bringing those mark-ups down. That’s particularly true when consumers are price sensitive . . . 

It’s been slow to sort of see that mark-up coming back down, but it’s a process that you would expect at this point in the cycle. So I’m certainly looking at that closely. And of course, that would contribute to disinflation in those sectors.

Though it has been slow, there has been some mean-reversion. The gap between core PPI with and without trade services peaked in August, since then shrinking a modest 11 per cent. Retailers and wholesalers are seeing their pricing power diminish a bit. But as Brainard says, we should expect to see more margin compression soon.

Mean-reversion of margins has also kicked in some among S&P 500 companies, a different sample than is captured in the PPI trade services data (large corporates vs retailers/wholesalers of any size). Operating margins, though they have narrowed, still look plump. They are around pre-pandemic levels, but they were well above their long-run average then. A recession or slowdown could bring them down further still (data courtesy of S&P’s Howard Silverblatt):

Line chart of S&P 500 operating margins, % showing Still hefty

Must margins necessarily mean-revert? Steve Englander of Standard Chartered points out that what investors want from firms is changing:

Our question is whether pressures to expand margins have become structural rather than cyclical. Many tech-based companies competed on market share in the pre-Covid period and were rewarded by valuations based on top-line revenue. With market expansion questionable and financing costs rising, the pressure may be to show bottom-line growth by widening profit margins. Businesses may show more resistance to narrowing them than consumers did in permitting their widening when they were flush with Covid-relief cash.

Perhaps, but we’re sceptical. Corporate cost-cutting can’t be taken in isolation. To contain inflation, the Fed needs consumer spending to fall, and that means many firms’ top-line revenue will fall too. To keep margins high and flat, companies will have to slash costs as fast as revenues come down. That is to say: brutal lay-offs, and probably a recession. Margins tend not to hold up in recessions. (Ethan Wu)

The strange case of industrial stocks

Here’s something weird: industrial stocks have done really, really well lately. Since September 30, the S&P 500 industrials are up 22 per cent, 10 percentage points better than the wider index.

This is weird because there is a widespread expectation that a recession is coming and industrial stocks are cyclical, and as such supposed to fare poorly heading into a downturn. It is very weird, to be more specific, that the 10 year-3 month yield curve is very inverted, screaming recession, and that shares in Caterpillar (big yellow construction equipment) and Deere (big green farming equipment) are both at all time highs.

Those are just two of the stocks that have done amazingly well of late. Here’s the top 15 performers in the group:

Bar chart of % price change, 9/30/22-11/25/22 showing Metal bangers

Nor is the group being dragged higher by a handful of big names. Of the 71 stocks in the S&P industrials, 58 have outperformed the index since the end of September, and only one stock has fallen (Generac Holdings).

It is tempting to look to interest rates to explain the rally, as many big industrial things are financed and because we explain everything with rates these days. But the result is not very satisfying. 10-year yields are about where they were at the end of September. Yes, industrials’ outperformance has picked up a bit since late October, as rates started to fall, but it’s hard to map the one neatly on to the other. Besides, if rates are falling because the Fed is successfully controlling inflation by killing demand, that’s an odd reason to buy a cyclical stock.

Furthermore, macroeconomic data seem to agree with the yield curve in anticipating a slowdown in demand for industrials’ products. Manufacturing new orders surveys have slipped into contraction mode:

I don’t have a good theory about what is going on here. It may be that the yield curve is sending a false signal, the economy will have a soft landing, and industrials will keep right on growing sales and earnings right through next year. Certainly, earnings reports from last quarter were very solid, with almost every company in the group reporting year-over-year revenue growth. Johnson Controls, a global manufacturer of heating and cooling systems, forecast earnings growth between 7 and 20 per cent for the fiscal year that just began; Caterpillar’s outlook, which is presented in qualitative terms, was benign, too. The question is whether, especially in heavy equipment and other industries with long order-delivery cycles, earnings are a lagging indicator.

Alternatively, industrials’ stock prices could be sending the false signal. Maybe momentum-chasing strategies are pushing the prices up, and we are coiling for a nasty reversal. I have no evidence of this, but things happen.

A final possibility is that we are seeing a longer-term sector rotation at work, as the growthy/techy stocks that did well at the height of the pandemic boom give way to old economy stocks (banks have done well lately, too, for example). Since the beginning of the pandemic in February 2020, industrials have performed in line with the S&P. What we have seen lately is, from that perspective, just a matter of industrials making up for their underperformance in 2021. Still, the timing is a bit odd.

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