Kelly Evans: How can margins NOT collapse?
Here's the problem with the blockbuster January jobs report: if it's for real, corporate profits are in trouble. And if it's not, then the economy is slowing.
Either outcome bodes poorly for the business cycle, which is why I can't get on board with those demanding more Fed rate hikes in response. But if we take it at face value that indeed the labor market is still this strong right now, it may well trigger its own demise, much like the old saw in commodities markets that "the cure for higher prices is higher prices."
Here's why: labor costs are now rising faster than overall prices. Core inflation, for instance, is running at 4.4% as of the last PCE report, while unit labor costs appear to be growing at about a 7% annualized clip. What happens when companies have to raise wages by more than they can raise their final prices? You guessed it: profit margins decline.
And what happens when profit margins decline? Layoffs. "Our base case continues to be margin compression in the first half of this year, triggering more layoffs around mid-year and recession in the second half," wrote Aneta Markowska of Jefferies last Friday.
We've seen a raft of similar warnings about what this means for stock prices, which have been on an eerie levitation since January 1. Lisa Shalett of Morgan Stanley cautions clients not to think this is the start of a new bull market. "Essentially, costs are rising faster than volume growth, pressuring profit margins...current dynamics seem stuck in a 'real contraction' trend, suggesting the bear market will continue," she wrote over the weekend.
To take one example, Colgate-Palmolive just posted weaker gross profit margins than expected, with a drop from 58% a year earlier to 55.6% last quarter. As a whole, net profit margins for the S&P 500 appear to be tracking just over 11% for the fourth quarter, down from a peak of nearly 13% in mid-2021, according to Bank of America.
Larry Lindsey issued a similar warning on our show yesterday, and he wrote after Friday's jobs report that its "implications are disastrous for corporate profits." If earnings remain as strong as they appear in the report, he warned, "corporate profits would have to fall by about 25% to accommodate that." Similarly, Peter Boockvar of Bleakley warned that "If [the report] is anywhere close to being accurate, productivity is plunging, and margins are in trouble."
In short, if liquidity were still exploding, prices surging, and the economy expanding sharply like it was from 2020-22, then you could have both higher wages and rising profits. But now, you can't. Liquidity is collapsing; firms can't fully pass these higher wages along anymore. They will ultimately have no choice but to trim workforces and get more efficient. On that note, it's kind of perfect timing for the "AI wars," with Microsoft holding a 1 p.m. ET unveiling of new products today (we'll have live coverage) that is the most exciting tech launch I can recall since the good old days of the iPhone.
But for now, it's unlikely that anything can save us from the imminent decline in profit margins that seems apparent. "Profit margins are at record--currently much higher than pre-Covid--and pricing power is likely to deteriorate from here," wrote J.P. Morgan equity strategists yesterday, saying they no longer are so sure that corporate earnings will remain resilient. Can we really ignite a new bull market in this kind of environment? Trade carefully.
See you at 1 p.m!
Kelly