A Recipe for Stagflation?

May 12, 2022

Source: Bloomberg Source: Bloomberg

The University of Michigan’s Consumer Sentiment Index rose in April but still represented the third-lowest figure in the past decade, so some find it interesting that U.S. companies are still showing exceptional profit margins. The SPX operating margin averaged 11.77 from 1990 to present, reaching a record high of 16.09 in January 2022. In March 2022, it fell to 15.88. 

After a relatively steady climb for the previous 12 months, many eyes are on this drop. Sharp decreases in profit are concerning as they often lead to layoffs, a precursor to cyclical unemployment, and are an early warning signal for a recession. Additionally, the advance estimate for gross domestic product (GDP) decreased at an annual rate of 1.4% in the first quarter of 2022.      

In the current rising-inflation environment, a slowing economy, layoffs and increasing unemployment could lead to stagflation. Stock market levels typically depend on sales, profit margins and the price-to-earnings (P/E) ratio; therefore, if the SPX operating margin drops back to the 11.77 average or lower, would the S&P 500 Index decline in response? And if so, by how much? 

In this week’s chart, we see operating margins had remained high despite inflation and wage growth. Some analysts suggest this was because large companies were able to manage costs and pass along higher prices to consumers. Unemployment remained low, the COVID-19 pandemic caused a behavioral shift toward value-based purchasing, the real GDP was 5.7% in 2021 and consumer confidence remains high despite low sentiment.      

The Present Situation Index decreased slightly in April but remains quite high, and the Expectations Index, while still weak, did not decline and ticked up slightly despite higher prices and the war in Ukraine. Additionally, the number of Americans applying for unemployment benefits hit a half-century low in the first quarter.

Other analysts suggest that operating margins remained high despite inflation because some of the high inflation had arisen from a mismatch of supply and demand. Vaccine rollouts, rapid reopening of businesses and stimulus dollars increased consumer demand extraordinarily while the supply chain was still struggling, further marred by COVID-19 variants and global conflicts, and simply could not keep up.      

Typically, prices rise for three reasons: increase in labor costs, increase in non-labor inputs and increase in profits. According to the U.S. Bureau of Labor Statistics, labor costs represent approximately two-thirds of the total cost for private U.S. companies, and historically, the bulk of price growth is due to changes in labor costs.      

In 2021, nonfinancial corporate profit was 15.3% of the price, up from 13.0% of the price in 2020; whereas unit labor cost (ULC) was 60% of the price, down from 62.2% in 2020. Additionally, the non-labor cost was 24.8% of the price, unchanged for both years, potentially suggesting that it was not cost-push inflation in 2021. First quarter numbers will be released on May 26 and it will be interesting to see if this trend continued into 2022.

We can see in the chart that both the Producer Price Index (PPI) and the Consumer Price Index (CPI) have been on the rise since the COVID-19 recession. Furthermore, in March, according to the U.S. Bureau of Labor Statistics, the PPI had one of the largest year-over-year percentage increases since the 1980s. In part, this was because commodities such as oil and jet fuel spiked. But for the last nine months, the PPI has been higher relative to the CPI, suggesting that inflation may persist and that companies may face greater difficulties passing rising costs to consumers in the coming months.      

Key Takeaway

Let’s circle back to the advance estimate for GDP. Considering that it decreased at an annual rate of 1.4% in the first quarter of this year, a pessimist might feel increased bearish sentiments and look at the inverted Treasury yield curve with trepidation. Will there be a liquidity squeeze? 

On the other hand, an optimist might see potential value in this decrease. If economic growth slows just enough to tamp inflation, companies pause pending projects to maximize capital efficiency and wage growth slows to a healthy equilibrium, U.S. companies may be able to sustain their strong operating margins for just a little longer.      

The rest of us will be looking at the risks, diversifying and adding assets such as commodities that may perform in the current economic environment.

Tags: Inflation | Unemployment rate | Wage growth | GDP | CPI

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