On Monday I was on the TD Ameritrade Network with OJ Renick to talk about the recent inflation data (you can see the clip here), money velocity, the ‘oh darn’ inflation strike, etcetera. But Oliver, as is his wont, asked me a question that I realized I hadn’t previously addressed before in this blog, and that was about inflation pressure on corporate profit margins.
On the program I said, as I have before in this space, that inflation has a strong tendency to compress the price multiples attached to profits (the P/E), so that even if margins are sustained in inflationary times it doesn’t mean equity prices will be. As an owner of a private business who expects to make most of the return via dividends, you care mostly about margins; as an owner of a share of stock you also care about the price other people will pay for that share. And the evidence is fairly unambiguous that inflation inside of a 1%-3% range (approximately) tends to produce the highest multiples – implying of course that, outside of that range, multiples are lower and therefore stock prices tend to adjust when the economy moves to a new inflation regime.
But is inflation good or bad for margins? The answer is much more complex than you would think. Higher inflation might be good for margins, since wage inputs are sticky and therefore producers of consumer goods can likely raise prices for their products before their input prices rise. On the other hand, higher inflation might be bad for margins if a highly-competitive product market keeps sellers from adjusting consumer prices to fully keep up with inflation in commodities inputs.
Of course, business are very heterogeneous. For some businesses, inflation is good; for some, inflation is bad. (I find that few businesses really know all of the ways they might benefit or be hurt by inflation, since it has been so long since they had to worry about inflation high enough to affect financial ratios on the balance sheet and income statement, for example). But as a first pass:
|You may be exposed to inflation if…||You may benefit from inflation if…|
|You have large OPEB liabilities||You own significant intellectual property|
|You have a current (open) pension plan with employees still earning benefits,||You own significant amounts of real estate|
|…especially if the workforce is large relative to the retiree population, and young||You possess large ‘in the ground’ commodity reserves, especially precious or industrial metals|
|…especially if there is a COLA among plan benefits||You own long-dated fixed-price concessions|
|…especially if the pension fund assets are primarily invested in nominal investments such as stocks and bonds||You have a unionized workforce that operates under collectively-bargained fixed-price contracts with a certain term|
|You have fixed-price contracts with suppliers that have shorter terms than your fixed-price contracts with customers.|
|You have significant “nominal” balance sheet assets, like cash or long-term receivables|
|You have large liability reserves, e.g. for product liability|
So obviously there is some differentiation between companies in terms of which do better or worse with inflation, but what about the market in general? This is pretty messy to disentangle, and the following chart hints at why. It shows the Russell 1000 profit margin, in blue, versus core CPI, in red.
Focus on just the period since the crisis, and it appears that profit margins tighten when core inflation increases and vice-versa. But there are two recessions in this data where profits fell, and then core inflation fell afterwards, along with one expansion where margins rose along with inflation. But the causality here is hard to ferret out. How would lower margins lead to lower inflation? How would higher margins lead to higher inflation? What is really happening is that the recessions are causing both the decline in margins and the central bank response to lower interest rates in response to the recession is causing the decline in inflation. Moreover, the general level of inflation has been so low that it is hard to extract signal from the noise. A slightly longer series on profit margins for the S&P 500 companies, since it incorporates a higher-inflation period in the early 1990s, is somewhat more suggestive in that the general rise in margins (blue trend) seems to be coincident with the general decline in inflation (red line), but this is a long way from conclusive.
Bloomberg doesn’t have margin information for equity indices going back any further, but we can calculate a similar series from the NIPA accounts. The chart below shows corporate after-tax profits as a percentage of GDP, which is something like aggregate corporate profit margins.
And this chart shows…well, it doesn’t seem to show much of anything that would permit us to make a strong statement about profit margins. Over time, companies adapt to inflation regime at hand. The high inflation of the 1970s was very damaging for some companies and extremely bad for multiples, but businesses in aggregate managed to keep making money. There does seem to be a pretty clear trend since the mid-1980s towards higher profit margins and lower inflation, but these could both be the result of deregulation, followed by globalization trends. To drive the overall point home, here is a scatterplot showing the same data.
So the verdict is that inflation might be bad for profits as it transitions from lower inflation to higher inflation (we have one such episode, in 1965-1970, and arguably the opposite in 1990-1995), but that after the transition businesses successfully adapt to the new regime.
That’s good news if you’re bullish on stocks in this rising-inflation environment. You only get tattooed once by rising inflation, and that’s via the equity multiple. Inflation will still create winners and losers – not always easy to spot in advance – but business will find a way.
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