For years U.S. inflation has been the dog that did not bark, but rising prices and wages are now showing signs of squeezing profit margins across corporate America, leading investors to punish companies whose results are deteriorating.
Investors have long focussed on rewarding firms that can multiply sales in a relatively slow-growth U.S. economy like Netflix Inc. and Amazon.com Inc., but they are now paying more attention to figures further down the income statement like expenses and pre-tax margins.
So far this year, companies with high operating leverage, which allows rising revenue to boost earnings while costs stay low, have seen their share prices rise 15%, beating their peers by nearly 6 percentage points, according to Goldman Sachs Group Inc. data.
Investors have also been rewarding firms with high and stable gross profit margins, according to the data.
Tax cut impact
But a shift in investor focus may now be occurring as the impact of U.S. corporate tax cuts encourages more spending and 10 years of ultra-low interest rates have stimulated economic growth and finally begun to push up prices and wages.
Large corporate tax cuts enacted last year boosted already hefty corporate profits, making most companies’ results look better by after-tax measures, but the benefit of the tax cuts also enabled companies to spend on talent and market share, sometimes raising expenses.
The other driver for investors’ increased focus on pre-tax margins may be inflation as industrial companies are forced to pay more for raw materials and companies dependent on consumer demand pay more in wages.
Take the case of Campbell Soup Co. which has seen its stock fall 30% so far this year on concern that packaged goods companies are struggling to pass on higher costs to consumers.
The canned-soup company reported “higher supply chain costs and cost inflation including higher transportation and logistics costs.” Another example is provided by power-tool manufacturer Stanley Black & Decker Inc whose stock is off 14% year-to-date despite beating Wall Street earnings estimates. Airline stocks also sank this year with crude oil prices up about 9% this year, pushing up jet fuel costs.
By contrast, companies who have managed to widen profit margins such as Zoetis Inc., which makes medicines for animals, Calvin Klein apparel maker PVH Corp, and agricultural product manufacturer Monsanto Co., have been rewarded with higher share prices this year.
U.S. headline consumer price inflation was 2.5% year-on-year in May and hourly earnings for private sector employees were up 2.7%, the Labor Department reported recently.
Rate increase expected
In its May “Beige Book” on business conditions, the Federal Reserve noted rising materials costs in some districts that are putting pressure on transportation, construction and manufacturing. The Fed is expected to raise interest rates again at its policy meeting next Wednesday as inflation and unemployment have come closer to the central bank’s targets but it will likely also keep an eye on corporate profit margins.
“Everyone is focused on interest rates... [and] on trade. But the risk everybody isn’t paying attention to is inflation,” said Charles Bobrinskoy, vice chairman and head of investment group at Ariel Investments.