Investors Beware: Decades-High Profit Margins Will Fall Hard As Inflation Cycle Ends
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Investors should brace for a sharp drop in nonfinancial companies' profit margins as the Federal Reserve raises official rates and shrinks its balance sheet significantly to reduce inflation. History shows that the unwind of inflation cycles tends to trigger an abrupt and sharp adjustment in margins as prices fail to cover overall costs.
According to the GDP data, real profits margins of 15.3% in 2021 for nonfinancial companies were the highest since the mid-1960s. The significant increase in profits margins, up 2.3 percentage points over the prior year, shows that firms passed their higher costs for materials, supplies, and labor to the end customer. Yet, the inflation cycle's flip side shows that margins get squeezed.
The last time the Fed faced an inflation cycle as large as the current one and expressed an explicit commitment to reduce it and achieve price stability was in the early 1980s (the Volcker war on inflation era).
On the surface, today's inflation rate looks less threatening than that of the early 1980s. The current one is more than a year old, while that of the early 1980s was a spillover from the high inflation rates of the late 1970s. Yet, if measured using the same methodology of the early 1980s, today's consumer price inflation rate is as high. Meanwhile, the producer prices for all three processing stages, finished, intermediate, and crude, are significantly higher.
So what matters more for reversing an inflation cycle; the length of the price cycle or the scale and breadth? Policymakers should presume all three matter, and it will take a significant increase in policy rates and luck to break the current cycle.
Price cycles are uneven on the way up and equally, if not more so when the process reverses. Policymakers' projection of a miraculous slowing in inflation to its 2% price target (i.e., roughly a 600 basis drop in the reported consumer price inflation rate) and not triggering destabilizing effects in the economy and labor markets is not credible.
Significant and sharp drops in inflation rates trigger sharp declines in operating profit margins as firms' consolidated costs do not fall as quickly. For example, in the early 1980s, operating profits margins contracted by 400 basis points, and other periods showed even more significant margins decline.
The reversal in the current inflation cycle will not require as big of a policy adjustment as in the early 1980s. Still, the counter to that is that the labor markets are much tighter, limiting how quickly the firms can control their overall consolidated cost structure. As a result, it would not be a surprise that at the end of this process, firms operating profits experienced a decline equal to that of the early 1980s.
Viewpoint commentaries are the opinions of the author and do not reflect the views of Haver Analytics.
Joseph G. Carson
AuthorMore in Author Profile »Joseph G. Carson, Former Director of Global Economic Research, Alliance Bernstein. Joseph G. Carson joined Alliance Bernstein in 2001. He oversaw the Economic Analysis team for Alliance Bernstein Fixed Income and has primary responsibility for the economic and interest-rate analysis of the US. Previously, Carson was chief economist of the Americas for UBS Warburg, where he was primarily responsible for forecasting the US economy and interest rates. From 1996 to 1999, he was chief US economist at Deutsche Bank. While there, Carson was named to the Institutional Investor All-Star Team for Fixed Income and ranked as one of Best Analysts and Economists by The Global Investor Fixed Income Survey. He began his professional career in 1977 as a staff economist for the chief economist’s office in the US Department of Commerce, where he was designated the department’s representative at the Council on Wage and Price Stability during President Carter’s voluntary wage and price guidelines program. In 1979, Carson joined General Motors as an analyst. He held a variety of roles at GM, including chief forecaster for North America and chief analyst in charge of production recommendations for the Truck Group. From 1981 to 1986, Carson served as vice president and senior economist for the Capital Markets Economics Group at Merrill Lynch. In 1986, he joined Chemical Bank; he later became its chief economist. From 1992 to 1996, Carson served as chief economist at Dean Witter, where he sat on the investment-policy and stock-selection committees. He received his BA and MA from Youngstown State University and did his PhD coursework at George Washington University. Honorary Doctorate Degree, Business Administration Youngstown State University 2016. Location: New York.