Costs have been corporate America’s worst enemy.
But now that inflation is coming under control, costs could become the C-suite’s best friend.
Sales have been surprisingly strong over the past several quarters, but they haven’t translated into impressive profit growth. Blame it on the rising costs of everything from labor to materials, which have eaten into profitability and forced businesses into what Wall Street calls an earnings recession.
Now, production-side prices — on energy, fuel, raw materials, and the like — have started to stabilize. Prices of some materials have even dropped lately. And in turn, companies are getting some relief on the bottom line, even with sales expected to slow in the quarters ahead.
It may not be the story of booming revenues that you hear about in good times. But it could be good enough to turn company profits around.
When costs matter more than sales
Pack up your chair and beach towel. Earnings season is upon us again.
Over the next six weeks, 90% of S&P 500 companies are slated to tell us how they did last quarter and what they’re expecting in the months ahead. It’s a good time to check in on how your portfolio’s companies are faring.
Unfortunately, they may not have much good news on the revenue front. S&P 500 sales could rise 7% year over year, according to analyst estimates, but that pace is expected to slow through the end of 2024. No surprise there: The Fed has the economy in a tight grip, and they probably won’t let go any time soon.
Luckily, costs matter just as much as sales in the profit equation. If costs are slowing quicker than sales, you may have a recipe for decent profits. And that’s what Wall Street is anticipating for 2024: 12% average year-over-year growth in S&P 500 earnings on just 5% growth in sales.
Costs have been the defining factor for company profitability in the inflation crisis. Costs of raw materials — fuel, metals, agriculture — grew by 11% at one point last year. Wages, which account for about 70% of business costs on average, have grown at an annual pace of nearly 6% over the past 12 months.
These seem like small changes, but they can add up. Eventually, businesses have to pass the costs onto customers. No wonder we’ve been living in a perpetual state of sticker shock.
The benefits of stable costs
Lately, the inflation tide has turned. If you were excited to hear that consumer price inflation slowed down in June, then you’ll be extra pumped to know that wholesale price inflation has moderated even more. The Producer Price Index, a gauge of wholesale prices, has risen just 0.1% over the past year. And on balance, manufacturers are actually paying lower prices now than they were in March.
Much of this relief came from energy prices and imported materials — delayed effects from lower oil prices and fixed supply chains. And if you look across industries, you’ll see that operating margins — a gauge of how profitable companies are through managing costs — could rise the most for consumer discretionary, industrial, and energy companies.
Regardless, relief in producer costs has helped boost forecasts for S&P 500 profit margins over the next 12 months. And eventually, these lower costs could flow through to the prices you and I pay.
Don’t ignore the cost of paying people, though. Wage growth is still at a brisk 4%. And while we all love a nice raise, a higher paycheck with even higher prices isn’t the kind of raise you want. Plus, wage growth could be bad for your portfolio if it erodes your stock’s profits through higher labor costs.
Luckily, wages are finally growing faster than inflation, which is good news for employees.
You may find that your paycheck is able to buy increasingly more, especially if you’re on the right end of these pay raises. Costs could add up again, but sales could help profits keep up.
So what does this mean for me?
Focus on profits. Profits are corporate America’s problem, but deep down, they’re our problem as well. When companies can’t make money, they’re more likely to cut costs and lay off people. And if you’re like most Americans, you rely on your job as your primary source of income. If companies lay off people en masse, then we could fall into a recession pretty quickly.
Keep an open mind. Stocks have done especially well during the last few earnings seasons, mainly because we’ve consistently underestimated companies’ abilities to weather such a tough environment. If you’re nervous about the future, consider the fact that we may once again be too pessimistic if costs really are coming under control.
Pay attention to earnings…the numbers and comments. When you’re scouring through earnings reports, focus closely on what’s reported — and what the C-suite says — about costs and profit margins. Cost management could be the most important story for companies in the coming quarters, and earnings season could present some interesting opportunities if you’re willing to do the research.
Think about how you’ll manage. Earnings season is a good time to utilize short-term instruments like options — if you have the risk tolerance for them, of course. Options could help you express a view in a cost-efficient way, and you wouldn’t necessarily have to sell out of your stock position.
*Data sourced through Bloomberg. Can be made available upon request.