Can margins expand further?

Good morning and brr. No, the money printer does not go “brr”; “brr” as in long johns. This week’s cold snap in the United States has disrupted what had been calm and fairly cheap. natural gas market. Gas prices rose 4 percent late last week and futures rose 5 percent. Analysts say gas prices could rise even more in the next two weeks, especially if cold weather disrupts supplies in Texas. Send us a warm and friendly email: robert.armstrong@ft.com and Aiden.reiter@ft.com.

Margins

Here’s an amazing chart from John Butters of FactSet (his weekly “Profit Outlook“The newsletter is always full of good things):

S&P 500 profit margins have been high since 2021, when stimulus checks arrived and post-pandemic demand unleashed. Inflation also helped. But the Wall Street consensus is that margins this year will surpass even the boom year of 2021, when margins were the highest in at least 30 years. And these wider margins are largely why the market expects double-digit growth in earnings per share this year.

Is this a rational expectation? It doesn’t seem like it. The economy is strong, but it is slowing gently. There is evidence of price pressure in some sectors (commodities, for example). The Federal Reserve has suppressed expectations of large drops in interest rates and therefore lower financing costs. There is also the potential for labor and input costs to increase due to the incoming administration’s tariff and immigration policies (which, according to home builders, for example, appears to be discount already.

The most common explanation for expectations of higher margins in the 25 is also the most common explanation for absolutely everything else related to the US stock market: the magnificent seven. The business models of megatech oligopolies have enormous operational influence. As your income increases, profits increase even faster. And, as the story goes, as these high-margin companies absorb more of the index (they currently make up a third), the index’s margins will increase as well.

It’s true that Mag 7s have been a big part of the margin expansion story in recent years. The question is whether this will be even more true in the next twelve months. This depends on two things: how much Mag 7 share prices rise (and therefore what part of the index they represent) and how much their margins increase this year. The first is difficult to predict. As for the latter, here is the trend in their operating margins (I use operating margins because it is difficult to see the trend in net margins, which are affected by tax rates and other charges):

Of the seven, margins at Nvidia, Amazon, Alphabet (Google’s parent) and Meta are trending upward. The margins of Nvidia, the second-largest magazine by value and the most profitable by far, are the most important variable. For Alphabet, Meta and Microsoft, their epic spending on capital expenditures should soon manifest as pressure on margins, through depreciation spending. How this all turns out is complicated and deserves an entire letter to itself.

However, the market does not only expect an expansion of margins from large technology companies. is waiting for him everywhere. Here, again from Butters, are the market’s net margin expectations by sector:

The market expects an expansion of margins in all sectors except real estate! And the expected increases are substantial even in “old economy” sectors, such as materials and industrials. Why would this happen?

There’s a reason why margins could rise sharply, suggests Society Generale’s Andrew Lapthorne: deflation in input costs.

Operating margins were impacted in 2023 as sales growth slowed and general and administrative sales [overhead] Costs couldn’t be reduced fast enough. But now selling, general and administrative costs are growing at the same rate as sales growth and the cost of goods sold is lower, i.e. lower input costs are helping. So there’s your margin expansion.

Here is Lapthorne’s graph of the percentage growth rate of the three index items, excluding the financial sector:

What’s more, as Citigroup’s Scott Chronert pointed out to me, there is some hope, or even expectation, that the manufacturing/industrial/cyclical side of the economy, which has been sluggish for a few years, will find a bottom and begin to recover. in the 25th.

But the idea of ​​a strong economy, driven primarily by consumers and services, getting even stronger as the cyclical side recovers, raises the specter of inflation.

Ian Harnett of Absolute Strategy Research offers this chart, which plots the US output gap as a percentage of GDP (that is, the amount by which the US economy is above its rate of sustainable growth, as estimated by the Congressional Budget Office) versus EBIT. margins:

It makes sense that when an economy is in full swing, margins are high. When demand is high relative to supply, companies have pricing power. But given this, it’s hard to see inflation staying on target or the Fed easing policy much. Harnett summarizes:

Today, when most people expect the new Trump administration to focus on keeping nominal growth strong (to keep the deficit under control), this implies that activity will remain above potential and therefore margins could be maintained.

The problem with this, however, is that it tends to imply a greater risk that inflation will be somewhat “sticky”, so that policy rates will also fall only modestly. . . [but] Many of the more cyclical areas of the global stock market are already pricing in a synchronized economic recovery.

The market expects fewer US rate cuts in 2025 than in November. But high hopes for improved margins reflect the view that we are still fundamentally in an easing cycle and, at the same time, the economy can remain strong or even strengthen. But that’s a difficult balance. Some margin improvement is possible this year. Sales growth and technology will help. But it seems to us that the market is waiting too long, even before we have seen what Trump’s promise of tariffs and deportations could mean for labor and input costs.

US consumer credit

Here is the total credit card delinquency rate, across all US commercial banks:

It finally started to decline last quarter, after the Federal Reserve cut rates. Good. But that sum hides many details. What about borrowers with less financial security? A clearer picture of this is provided by car loans made to younger (and therefore generally poorer and riskier) borrowers. The New York Fed’s third-quarter household credit and debt report showed things were improving there, too. Transitions to serious auto loan delinquency were steady or low for 18- to 29-year-olds and 30- to 39-year-olds:

A very good piece of Kansas Federal Reserve Last month offers another perspective. Using data from bank disclosures, the report shows that while default rates have increased for subprime borrowers, banks’ own assessment of the likelihood of loan default has remained stable since 2023:

Subprime mortgage delinquency rates have tended to lag banks’ default forecasts by 12 to 18 months, implying that delinquency rates will stabilize soon. This is great news for households, but not for those counting on multiple rate cuts from the Federal Reserve this year. Inflation was already above target as pressure mounted on subprime borrowers. If household finances begin to improve, giving consumers more room to spend, the case for the Federal Reserve to hold firm becomes even stronger.

(Reiter)

a good read

Well said Fred.