Who’s concerned about margin pressure?
Presumably everyone, although I suppose corporate management teams will be keen to downplay those concerns, especially in light of how many times the “peak profits” meme came up last month amid the U.S. equity rout.
It’s funny – back on October 6, we published something here called “A Terrible Trio Of Margin Headwinds For 2019“, which, frankly, I didn’t think a whole lot of people would be interested in. Markets are supposed to be forward looking, but the paradox in 2018 was that while everybody knew Q3 would probably be “it” in terms of peak bottom line growth, and although it was readily apparent that the stimulus would likely start to wane in Q4, it’s pretty hard to price that in ahead of time when the interim period is marked by record earnings growth and a voracious corporate bid for equities (i.e., a buyback bonanza).
In short, the interest in “what could go wrong?” didn’t seem to be too prevalent. But apparently, folks decided last month was the time to start pricing in the prospect of margin pressure from tariffs, wage inflation and rising rates. In other words: Everybody waited the last possible moment.
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Anyway, here we are in November following one of the worst monthly drawdowns since the crisis and folks are worried about margins. This week brought fresh evidence of wage pressures in the form of the fastest pace of private-sector wage/salary growth since 2008 (looking under the hood in the Q3 ECI report) and an average hourly earnings print on Friday that topped 3% YoY.
(Bloomberg)
That, during a week that started with reports indicating the Trump administration is prepared to move ahead with more tariffs on China in the event there’s no breakthrough on trade when Trump and Xi meet at the G-20.
It’s against this backdrop that Goldman is out with a review of what management is saying about margin pressures.
They start by stating the obvious, which is that because the imposition of tariffs on $200 billion in Chinese goods didn’t go into effect until September 24, the impact on Q3 results was limited. The question then, is what to expect going forward.
There are basically three ways corporate management teams can deal with the tariffs. They can reshuffle their supply chains, raise prices to consumers or pretend like tariffs aren’t an issue. Apparently, some folks are going to try that latter option first.
“Some executives insisted earnings of their firms would be largely unaffected by the tariffs”, Goldman notes, on the way to citing two examples as follows:
After assessing the “impact from the different sets of tariffs imposed by the US and China,” Qorvo (QRVO) reported that all existing tariffs were “immaterial on [their] business.” Similarly, eBay (EBAY) suggested that “most of the tariffs have been consumer goods and we haven’t seen very much.” Rollins (ROL) was “fortunate to be in an industry that is minimally impacted by trade talks or tariffs.”
As far as raising prices to consumers is concerned, that looks like it’s going to be the go-to option for “most managers.” Here’s a smattering of such allusions to rising prices as documented by Goldman in the same note:
Most managers expect to mitigate the effects of tariffs through price increases. Illinois Tool Works (ITW) commented that “for 2019, we estimate the impact of tariffs at around $60 million, which is based on all announced tariffs and tariff increases as well as any carry over from 2018. And we continue to expect that our pricing actions will continue to offset raw material cost inflation, including tariff impact on a dollar-for-dollar basis.” United Technologies (UTX) said “We have been able to more than offset the tariff impact through pricing this year. I would expect pricing will also have to increase next year if these tariffs remain in place.” Mohawk Industries (MHK) “continued to execute additional pricing across most product categories to offset ongoing price inflationary pressures.”
This is inevitable. The Trump administration’s protestations notwithstanding, corporations are not simply going to eat the costs associated with the trade war. Especially not in an environment where investors have come to expect that management teams share the market’s myopia when it comes to meeting or beating the Street every single quarter no matter what the cost. Demand destruction/lost market share takes a while to play out, so naturally, the default option will be to raise prices and see how things go. Of course that also means upward pressure on inflation and all that comes with that for the Fed.
Goldman goes on to cite W.W. Grainger and C.H. Robinson as examples of companies that are trying to shift their supply chains. Clearly that’s the ideal way to go about dealing with the tariffs, but it’s simply not feasible for a lot of companies, let alone on such short notice.
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There Will Be No Exemptions: Trump May Force U.S. Companies To Upend Supply Chains
Moving on to wage pressures (i.e., to another source of margin concerns), Goldman cites several examples of companies that have admitted the rising cost of labor will likely be a profit headwind going forward. To wit:
Firms acknowledge increased competition for labor. Robert Half International (RHI) explained that “as the labor market tightens, it’s just logical that you have to pay more.” Darden Restaurants (DRI) observed that “Restaurant labor was unfavorable 70 basis points, despite continued productivity gains and sales leverage. The increase was driven by hourly wage inflation of approximately 5%.” J.B. Hunt Transport (JBHT) noted that “Probably in the last 12 to 18 months, our driver wages are up about 10% or a little bit more than that.”
The only way out of that in a tight labor market is to increase productivity – best of luck with that. You can always “hire” some robots.
As far as rising rates go, that’s pretty straightforward. There’s a lot of leverage out there and either you can cover your interest expenses or you can’t (there’s more on fixed versus floating, etc. etc. here). “GS economics forecasts that 10-year rates will gradually climb to 3.4% by the end of 2019”, Goldman writes, adding that “although net leverage has increased sharply in recent years and stands near its post-crisis high, interest coverage ratios have remained healthy due to the low level of interest rates.”
The read-through is the same as it ever was: Shift your allocation to companies that have some pricing power unless you have good reason to believe Trump is all set to call off the trade war for good or unless you think recent wage gains are a temporary phenomenon in a world where the Phillips curve is truly dead.
