Consumers might still be benefiting from inflation pressures abating, but the same is no longer true for corporations.
Categories that provided relief to companies’ bottom lines over the past year—freight and energy prices, key commodities such as lumber, and supply chains—have either normalized and are unlikely to provide further benefits, or are reversing and will start to squeeze profits again. Companies will inevitably act to protect their profit margins. Whether they respond by cutting costs or once again prioritizing price increases over unit sales will determine whether the bigger risk in the first half of 2024 is recession or inflation. Neither outcome will be good for stocks.
Until recently companies benefited from declining inflation pressures even as revenue growth subsided. This allowed them to remain more profitable than investors had expected at the start of the year. Oil prices fell substantially between June 2022 and June 2023. Freight prices plunged in 2022, with the tailwind from those declines continuing well into this year as companies renegotiated shipping contracts. As supply chains untangled, manufacturers were able to get the missing components they needed to produce goods, ship and receive goods faster, and carry less inventory—all at lower costs than the year before.
This helps explain why the corporate earnings picture has pleasantly surprised investors, and why profit margins even managed to grow a bit in the second quarter. Slowing inflation that benefited both companies and consumers helped power the stock market this year.
Unfortunately, that no longer appears to be the case.
Oil prices have surged over the past three months as OPEC+ countries cut production. Airline companies, which feel the impact of more expensive oil immediately, have seen their stocks slump and recently cut earnings forecasts for the third quarter due to rising fuel costs as well as cooling demand for domestic travel.
Supply chains have shifted from improving to largely stable. We see this in the housing industry, where construction times have normalized. The drop in lumber prices, which helped homebuilders offset a softening housing market, is behind us with little room for further meaningful declines. Lennar Corp., the second-largest U.S. homebuilder, slid after it reported earnings last week as investors focused on the risk to profit margins from elevated mortgage rates.
And from here, interest rates remaining higher for longer will likely pressure corporate earnings in a way that policy tightening so far hasn’t. Companies took advantage of low interest rates in 2020 and 2021 to push out debt maturities for years, and are still benefiting from low-interest debt despite rising rates. But that's not a permanent phenomenon. As debt maturities approach, companies will have to issue more debt over the next year than they have over the past year. Rising interest expense is set to become a more significant headwind to profitability.
One persistent headwind has been the tight job market. Labor costs for companies are still growing and, as we've seen with United Parcel Service Inc. and now the big three domestic automakers, significant costs still need to be absorbed in some industries. The UPS stock has underperformed the S&P 500 significantly year-to-date in part due to a new contract with the Teamsters that was more expensive than investors expected. Presumably, United Auto Workers will negotiate a contract with significant improvements to pay and benefits for its members, curtailing auto company profitability.
The question as we head into third quarter earnings season next month is what corporate executives plan to do about all this renewed pressure on profit margins. If they choose to cut costs, it threatens the employment and economic growth outlook, and means the risk of recession in 2024 will rise. If they choose to do nothing, it likely means lower earnings guidance in line with what we've just seen from the airlines, increasing downside risk for the stock market. And if they choose to pass those higher prices on to consumers, it would raise the risk that inflation is on the rise again, putting the Federal Reserve on notice to consider further interest rate increases.
If there's a bright spot that could offset this dour outlook, it’s that the continued elevated federal budget deficit is pumping money into the economy to cushion both consumers and companies. The $2 trillion deficit expected for 2023 is cash that flows through the private sector, which helps support corporate profits and consumer spending, even as it contributes to inflation.
If you're wondering about whether recession or inflation is the biggest risk in the first half of 2024, pay attention to this corporate profit squeeze, and how companies respond to it. This, to some extent, is a choice that corporate America has to make, and starting next month we'll have a better idea of what they plan on doing.
Conor Sen is a Bloomberg Opinion columnist. He is founder of Peachtree Creek Investments.