Could Rising Costs Squeeze Corporate Profits?

The third-quarter corporate earnings season is set to kick off in the coming weeks, along with growing focus on profitability—namely, the impact of rising cost pressures on corporate margins, at a time when U.S. economic growth may be slowing, even as inflation remains historically high. 

In any case, earnings estimates remain robust, implying another year of double-digit profit growth ahead. Forward 12-month estimates are up more than 29% since Jan 1, and up about 2% since Aug 1.

Investor confidence in corporate profits is understandable, coming off the spectacular second quarter. Investors may be tempted to look past macroeconomic concerns, such as lower expectations for third-quarter gross-domestic-product growth, especially given a still accommodative policy environment.

Yet, signs have emerged of headwinds for corporate profitability in coming months and into next year. These include: 

• A widening divergence between producer costs and consumer prices: The producer price index, a proxy for corporate or wholesaler costs, has risen for eight months in a row and, in August, was up 10.5% from a year earlier, the highest reading since June 1981. Compare this to the consumer price index, a proxy for realized manufacturer or retailer prices, which was up 5.3%. This 5.2-percentage-point gap is one of the largest in more than 40 years, suggesting higher costs are outpacing merchant end-prices—a scenario that bodes ill for corporate margins.

• Increasing costs of distributing manufactured goods: Truck transportation costs, for instance, are running nearly 15% higher than year-ago levels. The World Container Index shows a 40-foot container going for $10,377, which compares with a five-year average of $2,396 and is three times higher than a year earlier. The Baltic Dry Index, a proxy for prices of global shipping from Asia, where most semiconductor supply originates, is at the highest level since 2005.

• Rising commodity and energy prices: A composite index of industrial metals, such as copper, zinc and nickel, sits at a 10-year high, up 47% from last year. As for oil, resilient demand and tightening inventories continue to support prices.

Such cost pressures will likely affect businesses across the board. In the U.S. stock market, the prices of many value-style stocks seem to reflect this risk of a potential profit squeeze. Yet, many investors continue to crowd into secular growth-style stocks, in what we believe may be a misplaced assumption that mega-capitalization growth stocks are somehow insulated from macro-level dynamics.

It comes down to who ends up bearing the additional costs. Companies that don’t pass through cost increases to end-prices will squeeze their profit margins. But, if enough companies pass on their higher costs to consumers, inflation could rise faster than expected, which could prompt the Federal Reserve to react earlier to contain inflation by both raising key interest rates and setting expectations for higher rates—raising the risks to growth stocks, valuations of which have been closely tied to low rates.

Investors should keep an eye out for earnings pre-announcements, guidance and revisions, as the third quarter wraps up and earnings season kicks into gear. Consider derisking portfolios, in line with our latest tactical asset allocation changes, by reducing equity overweights in favor of capital preservation, volatility management and opportunistic liquidity.

This article is based on Lisa Shalett’s Global Investment Committee Weekly report from Sep 27, 2021, “A Profit Squeeze?” Ask your Morgan Stanley Financial Advisor for a copy. Listen to the audiocast based on this report.