Given all the media attention afforded to so-called “greedflation” (typically defined by reference to near-record corporate profits), it’d be easy to come away thinking margins haven’t compressed at all.

While it’s certainly true that corporate profitability remains very, very elevated, margins are under pressure. The negative operating leverage thesis did play out, even if you didn’t notice.

In 2022, quite a few US corporate heavyweights conceded a costly error: They extrapolated pandemic trends into the indefinite future, leading to pockets of overcapacity. When demand for certain goods and services slowed, revenue growth flatlined against sticky costs, leading to margin compression.

The figure below, from Morgan Stanley’s Mike Wilson, illustrates the point.

The takeaway is straightforward: Unless you believe margins are likely to inflect imminently, revenue growth needs to hold up, or else earnings will succumb.

Wilson, champion of the negative operating leverage thesis this cycle, is still skeptical of any rosy view on margins, but he’s also concerned about sales.

“While we see margin compression continuing, we believe this year is also going to be about revenue growth falling unexpectedly as companies lose pricing power,” he wrote. “Unit growth is already deteriorating in many areas of the economy but many larger/high quality companies are still able to extract price to generate top-line growth.”

That’s the “price over volume” dynamic, and it’s been rewarded by shareholders in 2023. But it only works as long as consumers are willing to absorb price increases. You can get a good idea about when and where consumers are running out of patience simply by consulting anecdotal evidence. For example, flash PMIs released on Tuesday suggested activity in the US services sector is still robust. As Wilson wrote, some of the best pricing power resides in services.

In the end, it’s all about whether you believe the lagged impact of last year’s policy tightening and waning savings buffers will be sufficient to materially dent overall demand. If not, corporates will at least try to preserve margins even if that means losing some customers in the process of raising prices. In that scenario, the Fed would likely have to do more to curb consumption.

“[There’s] a strong argument that US firms are surprising and preserving their profit margins [but] our take is that EPS beats were on the back of lowered estimates,” SocGen’s Manish Kabra said Tuesday.

The figure above is simple, but compelling.

As Kabra remarked, “EPS growth is already negative YoY and cyclical leading indicators suggest two quarters of declining profit margins ahead.”