What effects would rising inflation have on business profits?

Profitability in the US has held up well in spite of the difficult economic backdrop.

>> Wage hike needs to keep up with inflation control

In the discussion about inflation in the US, there seems to have been lots of focus on the prices of inputs such as raw materials, particularly energy, and labour. But there’s been far less attention given to profit margins and that could prove a crucial error.

Profitability in the US has held up well in spite of the difficult economic backdrop. Pre-tax corporate profits in Q2 were just over USD3tr at an annual rate. That’s 50% higher than the nadir of USD2tr during the height of the pandemic. Of course, rising inflation has helped lift nominal profit levels but, even without this there’s little getting away from the fact that profits have been solid.

What’s more, in spite of the lack of growth in the economy this year, firms have been able to maintain profit margins. Corporate profits are around 15% of gross value added and that’s a very decent level in historical terms. In all it seems that while the prices of inputs such as energy and labour have undoubtedly been the key reasons why CPI inflation has soared, it is clear that, so far at least little of this price pressure has been counterbalanced at all by margin compression. This seems to irk politicians when it comes to industries such as energy. Complaints of ‘price gouging’ by such firms are rife, particularly among Democrats, which is why President Biden has threatened the sort of windfall tax that we’ve already seen many governments in Europe introduce. But it is not all about energy.

Around a quarter of the rise in corporate profits in the US over the past year are attributable to petroleum and coal products; suggesting that many other sectors are hardly struggling. But it is what’s to come that’s the issue as demand in the economy looks set to fall with a recession very possible next year.

The key question then will be whether margins will compress under competitive pressure and so add to any disinflationary pressure that comes from smaller rises in input costs? Mr. Steve Barrow, Head of Standard Bank G10 Strategy, said a fall into recession sees profit and profit margins fall and many US firms are starting to report that margin pressure is increasing given softening demand. However, there is another possibility which is that the structure of corporate America is such that firms will be able to maintain margins reasonably well.

>> Policy rate hike unavoidable to curb exchange rate, inflation risks

By the “structure of corporate America”, we’re really talking about the apparent lack of competition that exists in many sectors and industries. For while it is often thought that the US is uber competitive compared to the likes of Europe, for instance, there’s a good deal of evidence to say that it is the other way around. Not least the fact that stock market performance has generally been much better in the US than elsewhere for very many years; some of which likely reflects this pricing power. It has perhaps been most notable in those sectors where large companies have become very popular with investors such as the FANGs (Facebook, Apple, Netflix and Google). Now clearly the big hit that many of these stocks have taken does open the door to the idea that even such pricing power does not guarantee safety in the face of things like slumping demand or, in some cases, corporate missteps.

Nonetheless, Mr. Steve Barrow’s concern in this whole inflation story is that the apparent ability of firms in the US to maintain margins relative to their peers outside the US, could serve to make US inflation a bit stickier than we see elsewhere. That’s actually the opposite conclusion to that reached by the OECD in its economic review this week. It suggested that inflation will be sticker in Europe. Just who is right on this one could be important for how central banks respond with future rate cuts in coming years and potentially how currencies will respond as well.

“Our view is that the US dollar will tend to weaken against European currencies over the long haul but we don’t deny that this call could be frustrated if US profit margins prove relatively impervious to weaker demand, for this could keep inflation higher for longer, US rates higher for longer – and the dollar stronger for longer”, said Mr. Steve Barrow.