Cost Pressures and Profit Margins: Facts and Thoughts
May 07, 2008
By Qing Wang | Hong Kong
Clearer Macro; Murky Micro
GDP growth slowed to 10.6% in 1Q08 from 11.9% in 2007. The headline CPI inflation − albeit at a high level − appears to be peaking out. The downward trend in export growth has become more evident. Industrial production has also shown signs of moderation. While investment growth remained robust, consumption growth slowed in the aftermath of a deep stock market correction. With these developments, we believe an imported soft landing is now in sight. Specifically, we forecast that China's GDP growth will decline to 10% in 2008 while CPI inflation remains above 7% in 1H before starting to drop in 2H, averaging 6.5%. We therefore expect a continued muddling-through approach in policy implementation in 2008 featuring “three No's”: no campaign-style administrative tightening, no large one-off revaluation of the renminbi exchange rate and no aggressive rate hikes. In particular, we continue to feel comfortable with our “no rate hike throughout 2008” call. And we expect the de facto easing in policy controls (from the aggressive stance announced late last year) will become de jure as well sometime in 2Q. With less uncertainty about economic and policy outlook, we expect that the market will pay increasing attention to corporate profitability and the earnings outlook in view of the rapidly rising input prices amid a deteriorating external environment, pointing to a murky picture at the micro level. Cost Pressures and Margin Squeeze at the Aggregate Level The aggregate industrial data suggest that there does not appear to be an unambiguous and directional relationship between the cost pressures per se and profit margins. We use the difference in increases between ex-factory gate prices and raw materials purchase prices as an indicator of relative cost pressures. The larger the differences are, the bigger the cost pressures are. While cost pressures were quite low in 2001-02, profit margins failed to improve and instead dropped. Although cost pressures increased sharply in 2003-04, the profits margins improved substantially. During 2005-07, cost pressures were at high levels but eased over time, and at the same time, improvement in profit margins continued. Cost Pressures and Margin Squeeze at Sector Level We also examined the relationship between cost pressures and margin squeeze across sectors. We plot the relationship between profit margins and relative cost pressures for 36 industrial sectors. The relative cost pressures for each sector are estimated as the difference in the increases of each sector's ex-factory gate prices and the average raw materials purchase prices. The relationship between cost pressures and profit margins makes sense for 2004-07: industrial sectors that face heavier cost pressures tend to have lower profit margins. However, the reverse seems true for 2001-02: lower cost pressures are not associated with high profit margins. Understand the 'Inconsistency' There seems to be an inconsistency between the aggregate data and sector data in revealing the relationship between cost pressures and profit margins. While the aggregate data show no unambiguous relationship between cost pressures and profit margins, sector data generally confirm the existence of a negative relationship between cost pressures and profit margins. We think this has reflected profit redistribution among sectors when there is a large shift in relative prices of the inputs and final products among the industrial sectors. And this profit redistribution does not affect the overall profitability for the industry sector as a whole. The rather ‘abnormal’ relationship between cost pressures and profit margins at the sector level for 2001-02 suggests that when external demand is weak and the overall economy moderating, as was the case with the Chinese economy in 2001-02, firms would be unable to improve or maintain their profit margins even if cost pressures were low. With rapidly rising raw materials input prices, concerns about profitability and corporate earnings have intensified. We, however, want to caution against confusing relative price adjustment that may result in profit re-allocation among sectors with general margin pressures for the entire economy as a whole. We think there are two main channels through which cost pressures on profit margins can emerge: a) rising wages that allow labor to take a larger share of the value-added at the expense of the capitalist; and b) negative external terms of trade shock (i.e., rising prices for imports and/or declining prices of exports). These constitute ultimate cost pressures on the economy as a whole, and some or all sectors of the economy will have to bear the costs in the form of lower wages, lower profits or lower government revenue. Moreover, in an environment of weak external demand and a cooling overall economy, cost pressures will likely be of secondary importance in determining profit margins. In such an environment, maintaining market share and volume expansion likely take higher priority. Implications For the economy as a whole, the economic growth outlook and changes in the external terms of trade represent bigger risks to profit margins than rapid price increases in certain sectors, in our view. We expect industrial profit margins to be subject to increasing downward pressures, as the imported soft landing materializes over the course of the year. We, however, downplay the possibility of a double-whammy impact where the Chinese economy will suffer a major margin squeeze due to both headwinds from weaker external demand and mounting cost pressures. This is possible if international prices for primary products (which are China's main imports) continue to rise from their current levels despite a global downturn, and/or domestic wage pressures persist despite a soft landing of the economy. We attach a low probability to either scenario, however.
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Disconnect
May 07, 2008
By Richard Berner & David Greenlaw | New York
The dramatic improvement in credit and equity markets over the past few weeks echoes our belief that financial turmoil and systemic risk peaked in mid March. Credit default swaps for US leveraged lenders have narrowed by 150-200 bp to 40% of their mid-March peaks. CDS for a basket of 125 investment-grade nonfinancial borrowers, likewise, have narrowed by 63 bp, to 100 bp, and leveraged loan spreads have narrowed by 40%. Global stock prices have rallied by 10-20%. Volatility in both equity and bond markets has tumbled to three-month lows. Those rallies have the potential to turn a vicious circle into a virtuous one; they reflect the belief that the worst is over for the economy, and by reducing the cost of funds, can at a minimum cushion the downturn. Over the past week, better-than-expected economic US economic data and the disbursing of consumer tax rebates have buoyed hopes that the worst is over for the economy and recovery is coming. Forecast at a Glance
(Year-over-year percent change) | 2007A | 2008E | 2009E | Real GDP | 2.2% | 1.0% | 1.4% | Inflation (CPI) | 2.9 | 3.9 | 2.8 | Unit Labor Costs | 3.1 | 2.4 | 1.7 | After-Tax “Economic” Profits | 2.6 | -7.6 | 5.7 | After-Tax “Book” Profits | 4.3 | -10.0 | 6.2 |
Source: Morgan Stanley Research; E = Morgan Stanley Research estimates We disagree. In our view, the recent run of better data does not signal that recession risks are receding. If anything, there is a renewed disconnect between market pricing and our view of the economy: We think the economic fallout and resulting downturn is only beginning. While our baseline no longer includes two consecutive quarters of declining output, we’d still label this period a recession. Courtesy of the coming one-time bounce to consumer spending from tax rebates, and the subsequent payback, at best we envision a roller-coaster pattern of tepid growth and at worst a double-dip recession. And neither anemic growth nor a mild recession is any longer in the price. Indeed, reflecting higher energy quotes and slipping growth abroad, we see weaker US growth over the next few quarters than we did a month ago. For the four quarters ending in Q1 2009, we now see a tiny 0.1% growth; last month we expected 0.9%. Here’s why. We Question the Evidence of a Positive Inflection Point There’s no mistaking the influence on market psychology of better-than-expected US economic data; they have fostered hopes for an inflection point in the economy − in the sense that things are not getting worse, or at least are deteriorating at a slower rate. Notably, first-quarter real economic growth remained at a positive 0.6%, and upward revisions to construction data mean that the first estimate may be revised up to 1%. Nonfarm payrolls declined by only 20,000 in April, one-fourth of the average monthly decline in January-March, and the jobless rate declined by 0.1% to 5%. And corporate profits excluding financial and consumer companies appear to have risen by 11% over the past year. But as we see it, those data mask a significant underlying deterioration in economic activity, and we expect the growth in Q1 to give way to a 2% contraction in Q2. Domestic final sales declined in the first quarter for the first time in 17 years, reflecting weakness in both housing and business investment and tepid growth in consumer outlays. Only inventory accumulation kept output growth in positive territory, and we suspect the stockbuilding was involuntary. By any metric, real inventory-sales ratios have risen sharply in the past quarter, and some have risen for a year. Nondefense capital goods bookings have turned down in the past 6 months, and while unfilled orders are still rising, they tend to lag turning points. Vehicle sales in April tumbled to 14.3 million units, a 10-year low, and production cuts seem likely. And the better-than-expected payroll data hid a decline in the private and factory workweek, and thus a sharp 0.4% drop in labor inputs. Average hourly earnings rose a scant 0.1% in April, and almost certainly declined in real terms, hinting at weakness in consumer income. And our guess is that some of the earnings gain reflected profits on inventories, and much of it reflected overseas results. These more ominous signs of weakness in our view reflect important and ongoing headwinds to growth, including tighter financial conditions, falling home prices, rising energy and food quotes, and weakening income support. Tighter financial conditions? That statement seems to ignore the 325 bp of Fed ease since September, aggressive efforts to add liquidity to markets, and the resulting improvement in risky assets and thus in credit spreads noted above. But there are lags between changes in financial conditions and their effect on the economy. As we see it, the wider credit spreads and reduced credit availability of the past few months is just starting to hit the economy. And the April Senior Loan Officer’s Survey reinforces our concerns that the tightening continues. The percentage of domestic banks reporting tighter standards was “close to, or above, historical highs for nearly all loan categories in the survey.” In turn, a weaker economy will extend the deterioration in credit quality to businesses; losses continue to mount at lenders and among investors, eroding their capital base and keeping lenders cautious. Falling home prices are reinforcing that caution in three ways. First, they increase the probability of borrower default on existing loans, and higher realized loss severity forces lenders to raise new capital, sell other assets, curb lending, or some combination of those three. Second, they are prompting lenders to demand bigger down payments − “haircuts” − on new loans as a cushion for the expected decline in the value of collateral. Going from a 0 to 5% down payment environment to a 10-20% world is certainly safer, but the transition represents another dimension of reduced credit availability. Finally, the erosion in consumer balance sheets has prompted lender curbs on home equity and revolving credit lines, further constraining consumers. The upshot: The credit cycle has begun, and we think the time-honored interplay between a weaker economy and the credit cycle will restrain consumers and businesses for much of this year. The ongoing rise in global inflation represents a second threat to US and global growth. For the first time since the 1970s, global forces likely will keep US inflation elevated and could push it higher. The ingredients: soaring energy, food and commodity quotes, a weaker dollar, and rising inflation expectations. As a result, we think US headline inflation will remain at or above 4% through September. Over the past several years, the rise in energy and commodity prices was largely the product of booming global growth, especially in Asia and in China in particular. Improving living standards boosted the demand for protein and thus feedgrains, which underpinned a broader increase in food prices. Recently, however, we think that energy, food and commodity price increases are more the product of global supply constraints. That’s obviously hard to prove, but crude prices have jumped $30/bbl while most measures of OECD demand have slowed. The feed-through of energy quotes into fertilizer and agricultural production costs is unmistakable (see “Still Constructive on Fundamentals – Sell-off Presents Buying Opportunity,” by Hussein Allidina et al., March 24, 2008). And the metals boom is taxing the capacity of electric utilities in the metals-producing countries, promoting blackouts and further price hikes. A weakening US economy will eventually cap US inflation as the housing bust promotes a deceleration in rents and as slack in the economy undermines pricing power. But the relationship between slack and inflation has loosened in the past few years, so barring a significant downturn, underlying inflation will be sticky as sellers pass through some of those cost increases into retail prices (see “Upside Risks to Inflation,” Investment Perspectives, April 24, 2008). These developments also point to downside risks to discretionary income and growth. Indeed, the resulting loss in discretionary income from the start of the year nearly offsets coming tax rebates. We estimate that the rise in energy quotes between December 2007 and September 2008 will absorb an annualized $70 billion in consumer discretionary income, while price hikes in food − a much bigger share of consumer budgets − will drain about $50 billion from wherewithal. By comparison, the tax rebates that started going out to consumers at the end of April will amount to $117 billion by year-end. The rebates are going out sooner than we expected last month, and we now assume that they will boost spending a bit sooner than we expected. Although we still think that the boost to consumer spending will amount to about 2 percentage points annualized over the next six months, the drain from higher energy and food quotes implies a weaker net trajectory for consumer spending that will hold back overall growth. In that context, we expect that the post-rebate relapse in consumer spending in Q4 2008 and a post-incentive payback in capital spending in Q1 2009 likely will result in near-zero growth in those two quarters. Finally, overseas growth is beginning to soften. Business surveys, production, and retailing results are starting to turn down in Europe − an outcome our European economics team has long expected. Some economies in Asia, including India, and in Latin America are slowing. And rising inflation means that some overseas central banks cannot or will not respond to these threats to growth. Just as strong growth abroad helped keep the US economy out of recession over the past year (contributing about 40% of US growth), slower growth abroad likely will prolong the mild recession we think is now underway. Despite those downside risks to growth, we think that the Fed’s 25 bp reduction in the federal funds rate to 2% last week represents the trough in rates for this cycle. As noted, the Fed has eased aggressively and quickly, and it is time to take stock of the impact. Officials have to be gratified by the revival of activity in many parts of the capital markets. But a quick reversal in rates is unlikely, given the risks to the outlook, and we think the Fed will keep policy on hold for the balance of this year. Despite a likely post-rebate relapse in the economy, we don’t expect a “double-dip” recession. Officials probably welcome a period of subpar growth to help reduce inflation. A renormalization of monetary policy (i.e., tightening) is likely to begin around mid-2009. Reaffirming our Downbeat Calls on the Economy and Markets The rally in markets and better tone to recent data are challenging our call on the economy and those of our strategists on markets. After all, Mr. Market usually sniffs out changes in the economic landscape before economists and strategists do. Nonetheless, our strategy team and we are sticking to our discipline and our calls. For risky assets, the recent rallies imply that a worsening economy is now no longer in the price. Likewise, the flattening in sovereign yield curves has gone further than position unwinding, and now reflects some expectation that policy will reverse soon. Both may be short lived. In contrast, expectations about the Fed have begun to stabilize the dollar in FX markets, but the important news is that slower growth abroad is changing expectations about overvalued currencies like the euro. Even with a tepid US backdrop, therefore, we think the dollar is bottoming. The biggest risk to our call is that the economy and markets continue to trade in ranges that frustrate bulls and bears alike. But the biggest risk for bullish investors now is that downside surprises in the economy and earnings prove that the recent upswing was a bear-market rally after all.
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