Earnings, margins and inflation

Karsten Junius November 23, 2022 06:00

We have shown how inflation has helped earnings outpace margin expansions over the past 1.5 years. This process has started to reverse. With margins starting to decline from record highs, disinflation may become an additional headwind to earnings in a potential downturn.

However, sectors are unevenly affected. While some - such as pharma - have seen their earnings rise mostly as a function of inflation, others – such as materials - have also benefitted substantially from the strengthening commodity cycle. We have shown which sectors’ earnings appear most exposed in different growth -/inflation scenarios and concluded that earnings risks are higher in a disinflationary downturn than in a more typical downturn.

With the Q3 earnings season coming to an end, one notable observation is the drop in net income margins. They have fallen back to around 12% for the S&P500, the lowest level since Q1 2021. The decline has come from weak earnings surprises vs sales surprises, with growth rates for earnings and sales providing a similar picture. While earnings growth outpaced sales growth throughout most of 2021, these dynamics started to reverse in Q2 2022. This trend continued in Q3, with margins remaining under pressure.

We expect margins to come down further in the quarters ahead as the cycle should continue to slow. Yet this may not be the only headwind for profits. Over the past 1.5 years, US corporate earnings have clearly outgrown the pace suggested by expanding margins, driven by the sharp uptick in inflation. While operational leverage would typically lead earnings to grow at a faster pace than costs (margins expand), a broad rise in inflation lifts earnings and costs at a similar pace (margins remain stable). Growing earnings and stable margins are the result. As a consequence, earnings have gained from both, rising real demand and rising inflation. This can be shown by adjusting earnings for inflation, which puts them back in line with margins.

While this observation broadly holds for the market as a whole, there is quite some variety at sector level. Different sectors have been affected differently by the combination of rising demand and rising prices. Some have been able to benefit from both, seeing margins expand and earnings rise even more, while margins did not expand for other sectors, but those sectors still benefitted from generally higher price levels. Case in point for the latter is pharma, which saw earnings rise strongly over the past two years, while margins remained un-changed. Materials are an example of the former, with both operational leverage and rising inflation helped lift earnings.

Looking ahead, pharma earnings would likely suffer disproportionately (relative to S&P500 EPS) in a scenario in which inflation drops back to normal, without the cycle slowing significantly at the same time. As for materials’ earnings, they appear most exposed in a scenario in which inflation and the cycle are both slowing significantly.

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Karsten Junius

Chief Economist, Head Economic Research at Bank J Safra Sarasin