Quarterly Outlook
Fixed Income Outlook: Bonds Hit Reset. A New Equilibrium Emerges
Althea Spinozzi
Head of Fixed Income Strategy
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The importance of operating margin during inflation
Peter Garnry
Chief Investment Strategist
Summary: Since inflation began to accelerate in early 2021 low margin industrials have significantly underperformed high margin businesses. The market is recognising that low margin businesses are more sensitive to the ongoing wage pressures. This short-term pressure can be alleviated through cost cutting and layoffs, but the long-term competitiveness to rivals with higher margins could be devastating longer term as the low margin business will employees and get less talent.
Low margin businesses lose competitiveness during inflation
One of our main arguments when we published our mega caps equity theme basket was that during inflation mega caps would do better than the average because of their market power, brand recognition, wider and cheaper distribution, and access to cheaper capital. As we described in several equity notes inflation hits consumers and industries very differently, but one things is the same for all, the cost of capital goes up increasing the hurdle rate for businesses in creating shareholder value. Warren Buffett was very aware of this phenomenon during the 1970s and the experience of inflation led him and Charlie Munger down the road of finding businesses with strong moats.
The initial wave of inflation was easy for most companies because the excess stimulus meant that businesses could easily pass on their rising costs with little negative impact on the business. The second wave started late last year culminating in the Fed abandoning its belief that inflation was transitory setting in motion an interest rate shock in the year that followed. The second phase of inflation is not as easy as the first as employees are now requiring compensation for their lost purchasing power adding significant wage pressures in the economy. For low margin businesses this is a worrisome dynamic. The fact that you have a lower margin means that your sensitivity to wage pressures is higher than a competitor with a higher margin or just businesses in the same sector with higher margins.
The market has recognised this dynamic in its valuation. The chart below shows the 10% highest operating margin businesses in the industrials sector across North America and Europe compared to the 10% lowest operating margin businesses since December 2020 when inflation began accelerating. Part of the difference in total return is a repricing due to higher interest rates as the low margin businesses generally had a higher duration (interest rate sensitivity) from higher equity valuations, but the average P/E ratio of the 10% highest margin businesses was 41.5 back in December 2020, so the impact from interest rate sensitivity is most likely minimal.
In the short-term it can seem annoying for management in low margin businesses because profits are hurt, but the long-term impact could be far more devastating. Because if the higher sensitivity to wage pressures, low margin businesses will not compensate their employees for inflation as much as the high inflation businesses which could lead to higher employee turnover, brain drain, or forcing the low margin business into a massive layoff round which can become a productivity shock for the business that hampers growth for years. The market understands this dynamic and that is also why companies are rewarded for gains in profitability over revenue growth.
The US quit rate, which is number of people in the labour market that is voluntarily quitting their job, is at very elevated levels suggesting annualised turnover in the US labour market of around 30%. Quitters are getting twice the current wage growth of around 6.5% in the US, so the pressure on businesses right now are significant. The wage pressure dynamics and their impact on net profit margin is the key driver behind our negative view on earnings next year as companies will have a hard time offsetting the margin compression coming from wages as the economy is slowing down.
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