Canadian corporate profit margins have been rebounding as the economy heals from the shock of lockdowns two years ago. But there are challenges ahead as central banks raise interest rates, giving investors a good reason to be cautious.
Benjamin Tal and Katherine Judge, economists at CIBC World Markets, said in a research note that the profit margins for non-financial companies are “comfortably” above 2019 levels, and just 1 per cent shy when the booming energy sector is excluded.
Expanding margins have helped bolster corporate profits and underscored the bull market that has propelled the S&P/TSX Composite Index to a gain of about 80 per cent from its lows in 2020.
“The unique nature of the pandemic has generally rewarded many Canadian businesses with a quick rebound in profit margins,” Mr. Tal and Ms. Judge said in their research note.
Consumers – many of them locked down with nowhere to go – were less sensitive to prices, allowing companies to pass along higher production and labour costs without the usual adverse impact on demand, the economists added.
There is a longer-term trend toward fatter profit margins, as well. Since 2001, margins have been about 5 per cent, on average, after subtracting the rate of economic growth. That’s about double what margins were in the prior decade, largely because of factors such as globalization, innovation and the low cost of capital.
But Mr. Tal and Ms. Judge believe the supportive backdrop is now facing a number of challenges as the pandemic recedes.
One, interest rates are set to rise as central banks attempt to control inflation, with the annual rate now running at a 40-year high of 7.5 per cent in the United States.
Financial markets are already expecting a succession of rate hikes will begin next month, with some economists warning this rate-hiking cycle may not conform with the previous one, which ended in 2019.
“We may all need to start grappling with the reality that the Fed, and other central banks, will need to do more – potentially much more – than the prior cycle,” Douglas Porter, chief economist at BMO Capital Markets, said in a note last week.
Although low borrowing costs have encouraged rising corporate debt levels, many companies have rolled over their existing debt at lower rates, providing a temporary cushion as borrowing costs increase.
Still, Mr. Tal and Ms. Judge expect that even with a lag, corporate debt-service costs will rise, putting a dent in margins.
Rising wages could also have an impact.
The CIBC economists pointed out that labour compensation as a share of gross domestic product has fallen over the past two decades, owing partly to the rise of the gig economy.
Now, though, companies are struggling to find suitable workers and the bargaining power of labour has strengthened, putting upward pressure on compensation.
Margins may also be affected by the experience of snarled supply chains, which could push companies to hold more inventories closer to home and consider expanding domestic manufacturing.
“While nobody is talking about full-scale deglobalization, it is clear that more goods will be made in North America than before, carrying clear negative implications for margins,” the economists said.
How should investors interpret the erosion of a key support for the market?
David Kostin, chief U.S. equity strategist at Goldman Sachs, argued last week that U.S. profit growth over the next two years will have to come from revenue expansion rather than rising margins.
While cyclical sectors should see a continuing recovery in margins, he expects record-high margins within the information technology and communication services sectors will contract. The shift, which comes as higher interest rates weigh on equity valuations, is contributing to a less enthusiastic view of the S&P 500 this year.
But Mr. Kostin remains bullish: He trimmed his year-end target for the index to 4,900 from 5,100 previously, which still implies a gain of about 10 per cent from current levels.
“The macro backdrop this year is considerably more challenging than in 2021,” Mr. Kostin said in a note.
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David Berman