Easing Wholesale Pricing Won’t Increase Profit Margins

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Wholesale price inflation as measured by the producer price index hit its slowest pace in more than a year in October, data showed on Tuesday. But investors hoping that translates into higher profit margins for the S&P 500 index shouldn’t hold their breath: Margins are likely to remain tight for several quarters and possibly longer.

First, consider the counterintuitively positive relationship between PPI and profit margins. As it has done at other times in recent history, inflation has provided many companies with a hedge to ride out price increases beyond their wholesale costs. During peak inflation, politicians portrayed this as a sign of unchecked corporate greed (and, certainly, there is a case for that, but I’ll be a bit more charitable here). Companies were trying to line their pockets one last time — in C-suite parlance, they were fulfilling their fiduciary duties to protect shareholder interests — in an overheated economy that many suspected was heading into recession. Those record margins that companies have been posting lately may well turn out to be a last hurrah.

It turns out that the relationship between PPI and gross margins is almost always positive, as researchers at the Federal Reserve Bank of New York recently found. When producer prices go down, profit margins usually go down too, and that’s not shocking when you really think about it: both tend to go down during recessions. Therein lies the half-empty interpretation of recent improvements in the final demand PPI, which was up 8% from a year ago and just 0.2% from the previous month. . The decline partly reflects the unraveling of supply chains, but it also hints at a weakening in underlying demand. Excluding the volatile components of food and energy, the PPI remained stable from September to October.

It is also important to remember where the expansion of margins has come from in recent decades. When people think about the impact of lower wholesale prices, they probably have in mind businesses that sell physical goods, like retailers or automakers, which typically have low margins and can benefit from some additional flexibility through lower producer price inflation and even some deflation in the cost of inputs. If retail consumption remains buoyant – a big “if” – they can choose to pass on these lower costs or keep the extra margin to increase profits. But at the index level, it’s not retail that drives the big margins on the S&P 500; they are big tech companies. Over the past two decades, technology has consistently lifted index operating margins to new highs, pushing them to around 16% during the pandemic. At least in the short term, tech margins are set to suffer from wage inflation and rising energy costs in Europe, where many companies operate data centers for their cloud products. “The majority of expenses are personnel-related for a lot of these companies,” my colleague Anurag Rana, Bloomberg Intelligence’s senior analyst for technology, told me. That’s why some tech companies are quick to lay off workers; they know they have to choose their poison between preserving margins and protecting jobs.

The emergence of tech giants hasn’t been the only driver of higher margins over the past few decades, but the other drivers don’t look very good either. Globalization, which has reduced material and labor costs, appears to be taking a step backwards amid growing geopolitical tensions. And corporate interest rates on debt are likely to be higher for the foreseeable future – unless something breaks in the global economy, in which case corporations are in bigger trouble. That means the improved PPI — while good news for inflation fighters at the Federal Reserve — may not be as much of a win for corporate America. In the short term at least, the outlook is likely to deteriorate before it improves.

More from Bloomberg Opinion:

• Keynesian economics offers little value these days: Tyler Cowen

• Central banks have a break but cannot rest: Mohamed El-Erian

• Inflation doves want it both ways with CPI Quirk: Jonathan Levin

This column does not necessarily reflect the opinion of the Editorial Board or of Bloomberg LP and its owners.

Jonathan Levin has worked as a Bloomberg reporter in Latin America and the United States, covering finance, markets, and mergers and acquisitions. Most recently, he served as the company’s Miami office manager. He holds the CFA charter.

More stories like this are available at bloomberg.com/opinion

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