Proposals to rein in Corporate America’s profits, like the windfall tax that President Joe Biden wants to slap on oil drillers, are easy to dismiss as bluster. And yet, they’re an uncomfortable signal for corporate executives and shareholders: Record margins are coming up for blame in the inflation surge squeezing middle-class families.
That the diagnosis may be misguided – swelling margins are more transmitters of inflation than a root cause – only matters so much. If enough momentum builds to restore price stability by imposing curbs on corporate profits, it could become a problem for companies. The noise alone could spook investors and deepen a stock market slump that’s already wiped out $10 trillion.
“Investors should be aware,” Albert Edwards, the famously bearish strategist at Societe Generale, wrote in a recent note. “‘Excess corporate profits or, more pejoratively, price gouging, has come into the cross-hairs.”
How U.S. companies escaped Armageddon on the bottom line is an oft-told story this year. Faced with rising raw material and labor costs and overwhelmed by demand from cash-flush consumers, firms have pushed prices higher again and again. The result is visible in a chart of S&P 500 profitability. Margins, or how much of sales show up on the earnings line, have held relatively firm at 11% in 2022, not far from record levels.
That stickiness is being cited in some circles as an impediment to the taming of inflation.
“It’s not a coincidence that you’re seeing revenue gains basically in line with the sustained high levels of inflation,” said Julian Emanuel, chief equity, derivatives and quantitative strategist at Evercore ISI. He points to sales over the past year increasing between 7-11% per quarter, whereas prior periods saw growth of 3-6%. “That is almost exclusively driven by the ability to pass along costs. It’s pretty simple math.”
Corporate America’s cash machine has disproportionately fueled the inflationary boom, according to a study by Josh Bivens, director of research at the left-leaning Economic Policy Institute. He found that as price pressures were cranking up in 2021, fattening company margins accounted for more than half the increase. Labor costs contributed less than 8% – a flip of the dynamic that ruled from 1979 to 2019.
Those figures highlight what is actually a macroeconomic problem. The pandemic aid doled out by the Trump and Biden administrations was so massive that even today, U.S. households still have some $1.5 trillion in excess savings – money that generates such a steady wave of demand for shoes and cars and concert tickets that many companies are able to raise prices without losing customers.
Biden and influential Democrats in Congress are treating inflation as a problem of the microeconomy – a flawed approach, according to many economists, that’s designed in part at deflecting blame away from policy missteps. Legislation introduced in May by Sen. Elizabeth Warren would compel companies to disclose the rationale for charging more for their products. No action has been taken on the bill and chances are slim that the proposal will ever get through Congress. But Warren and other lawmakers have also backed a proposal that would allow the Federal Trade Commission and state attorneys general more leeway to investigate sellers that charge excessive prices.
The issue may end up being moot regardless, should margins come down on their own. While pricing power has been a boon to earnings for years, including this one, in which S&P 500 profits are forecast to rise nearly 10%, they’re viewed as a more or less certain casualty should a recession materialize in the U.S.. Estimates for earnings growth – arguably the biggest input for the direction of equities – sit at a relatively paltry 3% for 2023, and have been contracting for months.
That said, there’s plenty of evidence companies remain able to pass along costs while the labor market remains strong. Shares of Caterpillar Inc., for instance, last month surged after the company reported higher shipments of machines and increased prices across its end markets in the third quarter.
“Inflation is great for corporations’ sales growth,” said Zhiwei Ren, portfolio manager at Penn Mutual Asset Management.
Biden said he’d seek to impose higher taxes on oil companies that record “windfall” profits, a promise that will be all but impossible to deliver. Federal Reserve Vice Chair Lael Brainard made the case recently that inflation could slow if business markups retreated, saying that “there is ample room for margin recompression to help reduce goods inflation as demand cools, supply constraints ease, and inventories increase.”
Lisa Erickson, senior vice president and head of public markets group at U.S. Bank Wealth Management, says that companies are in a “tough spot right now” as labor costs remain high.
“What we’re going to continue to see is as long as price pressures remain, we are going to see companies likely needing to pass through some of those increases to consumers,” she said in an interview.
Seemingly unending price increases can heighten voter anger, putting pressure on politicians to act. President Richard Nixon in 1971 instituted a short-term freeze on prices and wages. It was, as Art Hogan, chief market strategist at B. Riley Wealth, put it, a disaster. Inflation kept climbing until the Federal Reserve finally jacked up interest rates to cool the economy.
“There’s an old saying that nothing cures high prices like high prices, and that just means that high prices tend to bring on incremental supply. That’s a self-leveling process,” said Hogan. “Injecting some policy in the middle thinking that’s going to help out just works in the opposite direction. We learned that back in the 70s.”
Companies are also, in such circumstance, hindered from making capital-investment decisions, said David Kotok, chief investment officer at Cumberland Advisors.
“What you do as a business enterprise is you postpone the long-term decision because you don’t know how to deal with it or how to price it. It’s a shame that we’re doing that,” he said. “Price controls, they didn’t work and history shows that they never really do.”
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