Corporate profits will not fall even if economic growth declines, because of inflation. That is the thinking many investors have when it comes to expected earnings growth for the next 12 months, which is still positive. But I think we are now past the stage where profits are still driven by inflation.
Operating leverage
Operating leverage reflects the extent to which a company can grow its profits by growing its revenue. Thus, companies with high fixed costs relative to their variable costs have high operating leverage and vice versa.
Often, operating leverage is seen as a static thing that is strongly related to the sector in which a company operates. But companies’ operating leverage is far from constant and depends to a large extent on the phase of the economic cycle.
The squeeze
In a phase of declining economic growth and recession - which we are now in - the prices of final goods (and services) come under pressure due to falling demand. At the same time, prices of inputs such as wages and rents often turn out to be “sticky. The result is lower profit margins.
Profit vs turnover
With the peak in inflation - apart from the energy factor, of course - in sight as a result of falling economic growth, companies now find themselves in a profit-unfriendly phase. The figure below substantiates this. It shows the trajectory of ‘earnings growth minus revenue growth’ of equities worldwide. This is a direct translation of the concept of operating leverage. As the chart shows, in the run-up to each of the last three recessions, operating leverage turned negative. Profits sank much faster than sales.
Headwinds
As a result of falling demand, inflation dynamics change. Companies can no longer endlessly raise their prices to pass on their higher costs. The prices of their goods start to fall first while costs, especially wages, continue to rise for the time being. Not least because labour markets worldwide are still very tight. This will put pressure on profit margins.
Jeroen Blokland is founder of True Insights, a platform that provides independent research to build diversified multi-asset portfolios. Blokland was most recently head of multi-assets at Robeco. His chart of the week appears every Thursday on Investment Officer.
This article originally appeared on InvestmentOfficer.nl.