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There’s been enough talk about US “greedflation” that it’s no longer very controversial to discuss systemically important prices.
US corporate profitability is still pretty high today, and it could rise further this year. Economists at Goldman Sachs expect nonfinancial companies’ profit margins to rise a bit this year, on aggregate, to 16.3 per cent.
They don’t think it’ll shift inflation very much, however. And there’s nary a word questioning the “efficacy of capitalism”, even with margins well above those supposedly worrying levels from 2016.
First, some quick context about how their aggregate profitability figures compare to history, and how they’re measured: GS compares nonfinancial companies’ profits to their GDP output. By that measure, corporate profitability reached the highest level since the 1960s in 2022 — excluding Covid-19-related government transfers — and still remain above the various peaks they reached in the decades between.
But inflation should slow even with high profit margins, says GS, because it will be offset by lower input (ie energy and materials) costs and lower labour costs to boot.
That’s not to say that Americans will immediately experience companies’ lower input costs as lower prices:
Intermediate input costs have declined by around 3% over the last year, and we expect lower costs to boost profit margins in the near term. While we have previously found that input cost changes are mostly passed onto final prices in the long run, we find that companies pass through input cost increases faster than input cost declines. Assuming intermediate inputs remain at their current levels, we estimate that lower input costs should boost nonfinancial corporate profit margins by 0.2pp in 2024.
This is not all that surprising, especially after the very clear demonstration of this dynamic we got with interest rates and banks. (When they fall, they fall for everyone. When they rise, bank customers don’t see it for a while.)
They also say something about AI and tech firms and margins. But as Alphaville readers will know, the AI hype appears to mostly be about labour costs. Those are also expected to fall this year:
Another way of quantifying the effect of wage growth on profit margins is to estimate the extent to which changes in wage growth get passed through to prices or get absorbed by profit margins. Using a set of industry– and state-level panel regressions, we estimate that a 1pp increase in wage growth boosts price inflation by about 0.3pp (Exhibit 9). Because compensation of employees accounts for around 60% of GDP, this implies that a 1pp decline in wage growth increases profit margins by roughly 0.3pp — the net of a 0.6pp decline in costs and a 0.3pp decline in prices.
Finally — and maybe most interesting — the economists look at how higher interest rates echo through companies’ income statements and into their profit margins.
. . . we estimated that firms pay for roughly 30% of higher interest expenses by reducing capex and labor costs, with the remainder absorbed by profit margins. This implies that higher interest payments will exert a roughly 0.1pp drag on profit margins this year.
That seems like a rather confident pronouncement. How did the economists come up with those figures? It’s from a note published in August of last year:
Using firm-level data on public companies since 1965, we estimate the impact of higher interest expense from refinancing on capital spending and employment. We find that for each additional dollar of interest expense, firms lower their capital expenditures by 10 cents and labor costs by 20 cents, about half of which comes from reduced employment and half of which comes through lower wages.
Hm. So this data window opened in 1965, when nearly 31 per cent of the private-sector workforce was unionised. But today, it’s about 7 per cent — modern workers find themselves firmly on the wrong side of that average calculation.
For unprofitable companies, the calculation is rather different and grimmer. And there are a lot more of them, according to that note from August 2023:
In previous research, we found that unprofitable firms disproportionately cut back on employment and capex when faced with margin pressure. The left panel of Exhibit 9 shows that almost 50% of all publicly listed companies were unprofitable in 2022. Unlike in typical recessions, the right panel of Exhibit 9 shows that the exit rate of unprofitable firms has declined since the start of the pandemic — likely in part due to the generous fiscal support that is no longer being provided — mirroring the economywide decline in bankruptcies.
This opens up a different line of debate for another time, which is whether the worries about zombie companies should be less about returns and more about employment and investment.
Luckily, companies’ refinancing needs aren’t that pressing, because so many of them issued debt when rates were low in 2020 and 2021.
GS found in last year’s study of interest costs that if companies kept refinancing debt at prevailing rates — Treasury yields were pretty close to current levels then — the median corporate bond’s coupon in 2025 would be just half a percentage point higher. That’s for both investment-grade and high-yield bond markets.
In other words:
Taken together, our estimates suggest that economywide nonfinancial profit margins are likely to edge up by around 0.1pp this year to around 16.3%, above the pre-pandemic level and last cycle’s peak. High profit margins should nevertheless be consistent with continued disinflation, as lower input and labor costs and shrinking scarcity effects will likely continue to push inflation down in 2024.
So, nothing to worry about here!? Freshly unemployed Americans can apparently enjoy $3-a-gallon gasoline prices while the corporate profits machine keeps rolling on. ¯\_(ツ)_/¯
