Profit Margin Pressures?

Warnings from Wall Street analysts and strategists of an impending drop in corporate profit margins have been issued repeatedly for the past several years. Although the oil downturn in late 2014 through early 2016 clearly dragged profit margins (and profits) lower, outside of that corporate America has been steadily producing record—or near record—profit margins for most of the past five years.

So what might corporate profit margins look like over the rest of the year? To answer that we can assess some of the key drivers of corporate margins: commodity prices, company efficiency, interest expense, tax rates, and wages.

By these measures, some margin pressures have built up over the past year. Commodity prices are higher, interest rates have risen, putting some upward pressure on borrowing costs, and wages are up—by 2.7% based on the average hourly earnings measure in the U.S. Department of Labor’s March employment report. The last two on this list, tax rates and efficiency, haven’t changed much recently.

So are the pressures on margins cause for concern? We don’t think so, primarily because the magnitude of the annual increases in these profit margin inputs is unlikely to repeat in the coming year. The year-over-year comparison for these inputs is distorted by the sharp drop in commodity prices, particularly oil, and interest rates during the first quarter of 2016. Even wage growth is supported by smaller increases a year ago. It is also worth noting that, although negative for many sectors, rising commodity prices and interest rates are a boon for others. For example, many financial firms benefit from rising interest rates; companies in the energy and materials sectors benefit from higher commodity prices.

The most important question is where profit margins go from here. Higher interest rates and commodity prices may put some pressure on margins over the rest of the year, but our expectations are for both to be largely range bound. Wages may rise, but we do not see meaningful acceleration given there is still some slack in the labor market. On a positive note, companies will continue to get more efficient as they have throughout the post-financial crisis earnings recovery, which helps support margins. Corporate tax rates are likely headed lower. Energy still has some lost margin from the oil downturn to recapture. Finally, don’t forget that faster revenue growth, which we are likely to see this year, helps create margin expansion opportunities through scale.

Bottom line, though corporate America may face some margin pressure in 2017, and despite the concerns on Wall Street, we expect only modest narrowing in S&P 500 Index profit margins over the balance of the year. We will get some insights into corporate profitability beginning this week as earnings season gets underway. For more on our expectations for this earnings season, please see our latest Weekly Market Commentary.



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