Profit Margins Are Getting Thinner

Profit Margins Are Getting Thinner
Reda Farran, CFA

over 1 year ago2 mins

Mentioned in story

When inflation’s riding high, footing the bill falls to two groups: customers and companies. You see, companies can offset some of their increased costs by boosting prices and passing the buck to the people who buy from them. But somewhere along the line, they typically have to swallow some of the elevated costs themselves, and that tends to squeeze their profit margins. We saw that pretty clearly during the third-quarter earnings season. See, 85% of the S&P 500 firms had reported their results by last Friday, and – based on the figures released – the average profit margin for the index over the third quarter of 2022 was 11.9%. That’s a full percentage point lower than the third quarter of last year, as you can see in the graph above. Put differently, profit margins have shrunk by 8% year-on-year – the first contraction since the start of the pandemic.

Now, falling profit margins are never a good thing, and they ultimately lead to lower earnings. In fact, Goldman Sachs just cut its earnings estimates for the S&P 500 for every year till 2024, saying that last quarter’s shrinking margins mean there’s even more pain ahead. The investment bank is now forecasting earnings-per-share to remain flat in 2023 – down from an earlier prediction of 3% growth. What’s more, it said that earnings could slump 11% next year if the US enters a recession. And it’s not the only one taking a dim view of things: many other banks are cutting their 2023 earnings forecasts for the S&P 500 firms.

The takeaway here is that the current macroeconomic environment is a challenging one for stocks. Higher interest rates are denting valuations, while snail-slow economic growth and inflated costs are sapping earnings. All in all, that means stocks might not look up until the broader economic environment takes a real turn for the better – till interest rates peak, for example, or the US economy avoids a recession. But don’t hold your breath just yet.

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