US profit margins are on track to suffer their first fall since 2015, as companies increasingly struggle to pass on costs of rising labour, transportation and raw materials to customers.
A record 58 per cent of respondents to the latest National Association for Business Economics survey of business conditions reported rising wage costs, while only 19 per cent reported that they had increased the prices they charged customers.
Analysts’ consensus forecast is for net profit margins to contract by 40 basis points in 2019, to 10.9 per cent, according to Goldman Sachs. Some on Wall Street are now bracing for an “earnings recession”.
The retreat from the post-crisis peak margins reached in 2018 signals a turn in the profit cycle that has powered the US market’s bull run and undermines an important prop for equity valuations ahead of the upcoming first-quarter reporting season.
It also marks a reversal from the confidence many executives had expressed last year that customers would continue to absorb rising wage and freight costs in a tight labour market and the impact tariff battles have had on raw material prices.
“We definitely are declining on margins,” said Howard Silverblatt, senior index analyst for S&P Dow Jones Indices, who said S&P 500 margins had not seen such a drop since the fourth quarter of 2015.
As a result, more companies may have to announce lower earnings guidance to “get ahead of the bad news” before the first-quarter earnings season peaks in April, he said, but “April is definitely going to be a test month”.
The “shadow” over corporate profit margins prompted Elga Bartsch, head of economic and markets research at the BlackRock Investment Institute, to warn last week of the risk of “a full-blown earnings recession in 2019”.
“US profit margins don’t look as strong as commonly thought once secular uptrends and favourable tax treatments are taken into account,” she wrote in a note to clients.
Margin estimates have been revised down for almost half of the companies in the S&P 500 since the start of the year, Lori Calvasina of RBC Capital Markets found, compared with upward revisions at just 18 per cent of the index’s members. The technology, materials and energy sectors saw the biggest downward revisions.
After those cuts to forecasts, and a larger than average number of companies lowering their earnings guidance, the constituents of the S&P 500 index are now expected to report a 1.7 per cent decline in earnings for the first quarter, according to data from Refinitiv. That decline is expected despite estimated revenue growth of 5.1 per cent.
While Refinitiv’s analysts do not expect an earnings recession for S&P 500 stocks — defined as two consecutive quarters of year-over-year earnings declines — they are forecasting such a contraction for US mid- and small-cap stocks.
Rising margins have been a powerful support for corporate America’s bottom line, which has also been aided by a sharp increase in spending on share buybacks. Companies in the S&P 500 spent a record $806bn on their own shares in 2018, S&P reported on Monday, beating the figure for 2017 by almost 56 per cent and shattering the previous record of $589bn that was set in 2007. But S&P expects the growth in buyback spending to slow to a “modest single-digit increase” in 2019.
The apparent end to a cycle of rising profitability will have winners as well as losers, Goldman’s analysts observed. Growing margin pressures have already led stocks with high pricing power to outperform, they found, and should also benefit companies with low labour costs.