A Terrible Trio Of Margin Headwinds For 2019

If you wondering whether Goldman is inclined to back away from their contention that the imposition of further tariffs on China could serve to materially dent expected EPS growth for S&P companies in 2019, the answer is “no”.

Late last month, Goldman calculated a kind of worst case scenario for profit growth next year in the event the Trump administration moves ahead with duties on the entirety of Chinese imports. As a quick reminder, the latest round of tariffs on China involves a 10% tax on $200 billion in goods. The rate will move to 25% starting in 2019 assuming there are no breakthroughs between now and then.

The delay in the imposition of the higher tariff rate is apparently designed to give corporate management teams time to rework their supply chains in order to avoid a scenario where input costs rise. Of course the idea that giant corporations are going to be able to rethink their entire supply chain strategy and strike new deals within 90 days is laughable in the extreme. The fact that the Trump administration initially did not provide a process for exemptions indicated that the President is serious about effectively forcing companies to find ways around China. That, in turn, is a testament to the notion that Trump is determined to upend the global order when it comes to trade and commerce.

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More worrisome than that is the administration’s penchant for viewing retaliations from Beijing as escalations. That’s an absurd way to look at things (i.e., “I hit you, and you hit me back, so now you’re the aggressor”), but such is life in the Trump era. China of course has retaliated and tensions were ratcheted higher still this week when Bloomberg revealed a massive hacking effort and Mike Pence doubled down on the administration’s contention that Beijing is seeking to meddle in the midterms.

In short: The odds that Trump goes “all in” by slapping tariffs on the entirety of Chinese imports are now pretty high and it seems logical to assume that the end game is a 25% levy on some $500 billion in goods.

Goldman’s contention is that in that scenario, and assuming no input substitution and no pass-through to consumers, EPS growth for the S&P 500 will flatline next year. Why would, as alluded to here at the outset, the bank be inclined to walk back that contention? Well, because this week, Council of Economic Advisers Chairman Kevin Hassett went on CNN and said that Goldman “almost at times looks like the Democratic opposition”.

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Fast forward to Friday evening, and the bank reiterated their contention about the effect of tariffs on corporate profit growth in America.

“If a 25% tariff is placed on all imports from China, our estimate of 2019 S&P 500 EPS, currently $170, could fall as low as $159, eliminating all expected earnings growth”, the bank wrote, before underscoring the notion that the scenario in question “uses conservative assumptions: no substitution to other suppliers, no pass-through of costs to consumers, no boost to domestic revenues, and no change in economic activity.”

The reiteration of that point comes in the course of a broader discussion about margin pressures going forward which is itself part of a larger discussion about the prospect of a sharp acceleration in wage growth. Throw in rising interest rates and you’ve got a trio of potential headwinds for margins:

1. tariffs
2. wage inflation
3. higher rates

You already know the tariff story and when it comes to wage inflation you probably have a good idea about recent trends. Although we’ve yet to see the kind of rapid acceleration in wage growth you’d expect given where unemployment is, there are nascent signs of pressure and the Amazon news only served to heighten concerns.

“AMZN’s announcement of a $15 minimum wage for all US employees has spurred discussion of economy-wide wage inflation [and] although this change will not impact the 3Q results of the S&P 500’s 2nd largest employer, investors will be observing the responses from other firms”, Goldman writes, in the same Friday note mentioned above, adding that as far as small businesses are concerned, “a recent NFIB survey showed one-third of respondents reporting labor cost or labor quality as the single most important problem affecting their business.”

(Goldman)

It goes without saying (or at least it should) that if Democrats manage to gain ground in November, the push for corporate management teams to focus more on compensation, capex and R&D and less on shareholder returns, will gather momentum, perhaps adding to upward pressure on wages and downward pressure on margins.

For their part, BofAML doesn’t think the Amazon news will have a material impact at the economy-wide level. “We do not think the pay increase will have a significant and sustained impact on aggregate wage growth”, the bank writes, in a note dated October 3. “Our back of the envelope calculation suggests that the increase in Amazon’s minimum wage is likely to contribute at most 0.1pp to the mom growth rate in the November employment report”, they continue.

As far as rates go, Goldman notes the obvious which is that “rising yields should weigh on firms with the heaviest debt load, as higher rates flow through to higher interest costs.” That like means you should focus on strong balance sheet companies going forward.

On that latter point, it’s worth noting that SocGen’s Andrew Lapthorne has been pounding the table on balance sheet risk in the U.S. for what seems like (and probably is) years.

“US corporate balance sheet risk is clearly a known problem as positioning is very much aligned along balance sheet quality lines, and the strategy is performing strongest where balance sheets are weakest (i.e. in the US, but not in Japan or Europe)”, he wrote last Monday, describing the following chart:

(SocGen)

Of course we’ve heard all of this before and it never seems to play out exactly like it “should”, in part thanks to tax cuts which bolstered corporate bottom lines at a time when profits might have started to inflect lower. But who knows, maybe the stars have finally aligned when it comes to putting pressure on margins which, you’re reminded, are pretty fat right now.