Profitability is next sacrifice at the inflation altar

LONDON - The main event in the inflation battle royale now features Jerome Powell and Christine Lagarde squaring off against Mark Zuckerberg and Bernard Arnault. Before the U.S. Federal Reserve and European Central Bank chiefs feel comfortable enough slashing interest rates much, they will want reassurance that the bosses of Meta Platforms, LVMH and other companies refrain from passing on higher wage costs to consumers, which would risk rekindling a broader jump in prices. For this to happen, profitability is likely to suffer.

For the past two years, a question has lurked in the corridors of major economic powers: Is corporate greed on full display or have business conditions just achieved some sort of healthy equilibrium following the sharp uptick in living expenses, mortgages, manufacturing costs and salaries?

The essence of the riddle relates to how corporate bottom lines swelled following an epochal pandemic and war arriving on Europe’s doorstep.

In each of 2021 and 2022, a group of more than 700 large companies generated at least $1 trillion of combined windfall profit, defined as 10% more than their respective averages over the previous four years, according to charities Oxfam and Actionaid. As energy and food prices soared, and medicines were in high demand, it’s no surprise that companies such as Exxon Mobil recorded the highest net profit ever for any Western oil producer at $56 billion in 2022, Pepsico churned out four consecutive years of record operating profit or drugmaker Merck & Co nearly doubled pre-tax profit between 2018 and 2022.

They were not the only beneficiaries of a world upended by disease and armed conflict, however. Rising corporate profit has accounted for almost half the spike in euro zone inflation since the start of 2022,

the International Monetary

Fund found.

Labour costs only contributed 25% to price growth during a period when the bloc’s inflation reached an eye-watering 10.6%. The United States experienced a similar trend. Corporate profit as a share of gross domestic income touched the highest level since 1966 in both 2021 and 2022, just as inflation jumped to a peak of 9.1% from 1.4%.

The flexing of corporate muscles as millions of people were dying from Covid-19 while millions more struggled to pay their bills sparked an inevitable backlash. Politicians such as U.S. Senator Bob Casey, a Democrat from Pennsylvania, accused companies of price gouging. Oxfam called profit levels “obscene” and lobbied for punitive taxes, while the Greek government tried to protect consumers by capping retailers’ profit margins on essential products at 2021 rates.

wading

Central banks are now wading into these politically charged waters. Although price growth has abated – both because of natural economic forces and steep interest rate hikes – wage growth has picked up after a long period of stagnation. For example, average hourly U.S. earnings in February increased 4.3% from a year earlier, well above a pace consistent with the Fed’s 2% inflation target. Lagarde, Powell and Bank of England Governor Andrew Bailey have warned that higher salaries might lead to an unwelcome rebound in inflation unless companies and their shareholders shoulder some of the burden.

Lagarde has been the most explicit of her peers, repeatedly urging, boardrooms to “absorb” rising wages. The message is clear: before cutting rates, policymakers want to see lower corporate profitability. CEOS seem to be paying attention. In the eurozone, the share of gross value added – a measure of economic output – taken up by non-financial companies dipped nearly 2 percentage points, to 40.2%, in the third quarter of 2023 from the mid-2021 rate. A big reason is that the bloc’s per-unit profit is slowing down. This particular profitability yardstick had been soaring, rising at a 9.3% annualised rate in the last quarter of 2022. By the end of 2023, it had shrunk to 3.3% year-over-year, according to Bank of America analysts. The deceleration is pulling prices down, and many companies are feeling the disinflationary winds.

For example, Unilever, whose brands range from Vaseline skin care to Knorr soup mixes, generated an 18.5% operating margin in 2020. By last year, it had dropped below 17%. Oil titan Shell experienced something similar. Its operating margin bounced from 10% in 2021 to nearly 16% in 2022, before slipping back to about 12% last year.

Greedflation

U.S. greedflation fighters have been less successful. S&P 500 Index members reported a collective operating margin of 13% in 2023, within a whisker of its 2021 peak and a full 2 percentage points higher than the pre-pandemic level, according to Lisa Shalett, chief investment officer in Morgan Stanley’s wealth management division. With economic growth strong and inflation tracking higher than the Fed’s 2% target, robust corporate profitability may force Powell’s Federal Open Market Committee to wait before it reduces benchmark borrowing costs.

Look closer, though, and a slightly different picture emerges. Excluding the “Magnificent Seven” – Alphabet, Amazon.com, Apple, Meta, Microsoft, Nvidia and Tesla – the margin for S&P 500 members is 11.6%, about 1 percentage point below its all-time high. It’s a more comforting calculation for Powell than it is for equity investors anticipating a record-breaking run predicated on a roughly 25% uplift in earnings between now and 2025, according to Wall Street analysts. Expanded margins will have to play their part.

Big Tech may be able to power growth in earnings and margins on their own, especially if artificial intelligence breakthroughs live up to the hype. At Facebook owner Meta, for one, analysts expect earnings per share to rise 34% this year and its EBITDA margin to jump to 51% from 43% last year, based on estimates gathered by LSEG.

Some European companies may be able to keep up, too. LVMH, whose luxury cupboard is stocked with everything from Christian Dior couture to Hennessy cognac, is projected to boost its operating margin to 28% in 2025 from 26% in 2023. Overall, however, the operating margin for companies in the STOXX Europe 600 Index is expected to contract to 8.5% at the end of 2024 from about 9.8% now, Bank of America analysts reckon. If that’s the trajectory, it is hard to see how shares will keep rallying from record to record. Whether or not Powell, Lagarde and Bailey are willing to say it explicitly, this sort of drop-off is what they would like to achieve. And they probably will keep interest rates higher until they see corporate profit margins cracking. “Don’t fight the Fed,” renowned investor Marty Zweig warned the market in 1970 to help explain the correlation between central bank policy and the movement of stock prices. The same principle applies to today’s CEOS.