Margins are still too high

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Margins are still too high

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

The pink line above excludes the price impact of trade services from retailers and wholesalers. Say you’re Walmart. You buy a bunch of stuff in bulk, unbox it, dust it off, and neatly store it on your shelves for customers to check out. You have not modified the product at all; you’re more in the business of making buying things fun and easy. In return for your time and effort, you mark up the price. This mark-up corresponds to the value of commercial services in the PPI index.

In other words, business services measures the gross margins of retailers and wholesalers, which have exploded over the past two years. The basic story here is that a combination of broken supply chains, rising input costs and strong demand created pricing power for producers, which increased margins. These increases, visible in the widening gap above, are fueling inflation.

This dynamic has not gone unnoticed. Here’s Fed Vice Chairman Lael Brainard from earlier this month:

The data isn’t exhaustive, but certainly in the retail industry, you can look at retail margins, versus wage growth in that retail business. And you can look at that markup and how it compares to inventory to sales ratios.

So normally, as inventory-to-sales ratios go up, you would actually expect increased competitive pressure to start cutting into those margins. This is especially true when consumers are price sensitive. . .

It has been slow to see that margin decline, but that’s a process one would expect at this point in the cycle. So I’m watching this closely. And of course, that would contribute to disinflation in those sectors.

Although it was slow, there was some reversion to the mean. The gap between the basic PPI with and without commercial services peaked in August and has since narrowed by 11%. Retailers and wholesalers are seeing their pricing power decline a little. But as Brainard says, we should expect to see more margin compression soon.

Margin reversion has also occurred at some S&P 500 companies, a different sample than captured in PPI trading services data (large companies vs. retailers/wholesalers of any size). Operating margins, while shrinking, still look plump. They are around pre-pandemic levels, but were well above their long-term average then. A recession or slowdown could push them down further (data provided by S&P’s Howard Silverblatt):

Do margins necessarily have to revert to the mean? Steve Englander of Standard Chartered points out that what investors expect from companies is changing:

Our question is whether the pressures to increase margins have become structural rather than cyclical. Many tech companies competed for market share in the pre-Covid era and were rewarded with revenue-based valuations. With questionable market expansion and rising funding costs, the pressure may be to show earnings growth by expanding profit margins. Companies may show more resistance to reducing them than consumers did in allowing them to expand when full of Covid relief money.

Maybe, but we are skeptical. Reducing business costs cannot be taken in isolation. To contain inflation, the Fed needs consumer spending to decline, which means many companies’ sales will also fall. To maintain high and stable margins, companies will need to cut costs as fast as revenues fall. That is to say: brutal layoffs, and probably a recession. Margins tend not to hold up in times of recession. (Ethan Wu)

The strange case of industrial stocks

Here’s something weird: Industrial stocks have been doing very well lately. Since Sept. 30, the S&P 500 industrials are up 22%, 10 percentage points better than the broader index.

This is bizarre because there is a widespread expectation that a recession is approaching and industrial stocks are cyclical and as such supposed to perform poorly before a recession. It is very odd, to be more specific, that the 10-year-3-month yield curve is very inverted, crying recession, and that the stocks of Caterpillar (large yellow construction equipment) and Deere (large green agricultural equipment ) are both highs at all times.

These are just two of the stocks that have done incredibly well lately. Here are the 15 best artists of the group:

The group is also not driven higher by a handful of big names. Of the 71 stocks in S&P Industrials, 58 have outperformed the index since the end of September, and only one has fallen (Generac Holdings).

It’s tempting to look to interest rates to explain the recovery, because so many big industrial projects are being funded and because we explain everything with rates these days. But the result is not very satisfactory. 10-year yields are roughly where they were at the end of September. Yes, industrial outperformance has picked up a bit since late October as rates started to come down, but it’s hard to match up. Also, if rates are falling because the Fed is successfully controlling inflation by killing demand, that’s a strange reason to buy a cyclical stock.

Moreover, the macroeconomic data seem to agree with the yield curve, anticipating a slowdown in demand for industrial products. Surveys of new orders in the manufacturing sector have gone into contraction mode:

You see a snapshot of an interactive chart. This is probably because you are offline or JavaScript is disabled in your browser.

I don’t have a good theory about what’s going on here. It may be that the yield curve is sending the wrong signal that the economy will experience a soft landing and industrialists will continue to increase sales and profits throughout next year. Admittedly, last quarter earnings reports were very strong, with almost all companies in the group reporting year-over-year revenue growth. Johnson Controls, a global maker of heating and cooling systems, forecasts earnings growth of between 7% and 20% for the fiscal year just begun; Caterpillar’s outlook, which is presented in qualitative terms, was also benign. The question is whether, especially in heavy equipment and other industries with long order and delivery cycles, profits are a lagging indicator.

Alternatively, industrial stock prices could send a false signal. Perhaps momentum-hunting strategies are driving prices up, and we are setting ourselves up for a bad reversal. I have no proof of this, but things happen.

A final possibility is that we are seeing longer-term sector rotation as growth/tech stocks that performed well during the height of the pandemic boom give way to old economy stocks (banks also performed well lately, for example). Since the start of the pandemic in February 2020, manufacturers have posted performances in line with the S&P. What we’ve seen recently is, from this perspective, just a matter of industrialists making up for their underperformance in 2021. Still, the timing is a bit odd.

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