American corporations may disagree with fund managers that a potential trade war is the biggest “tail risk” facing the U.S. stock market, but that doesn’t mean they’re expecting smooth sailing ahead.
Coming off one of the strongest quarters in recent memory, in terms of both earnings and revenue growth, as well as the percentage of S&P 500 companies beating forecasts, corporate management teams have begun to suggest that the operating environment will likely become somewhat more difficult in the second half of the year.
The reason? Rising costs and the impact that could have on companies’ record-high margin levels.
According to the Goldman Sachs “Beige Book,” an analysis of major themes discussed in the earnings calls of S&P 500 SPX, +0.12% companies, margins were the primary issue to get unusual attention over the reporting season, with another issue—wage growth—deeply connected to the first.
Read: As goes trade, so goes the stock market, Goldman warns
While both factors were cited in previous Beige Books, the one for the first-quarter season was more positive in tone, with corporate executives generally expressing optimism about the state of the economy. In the February Beige Book, released shortly after the tax-reform bill was passed, executives were far more bullish on the economy.
Profit margins are currently at all-time highs, per Goldman’s data, but the current level could represent a peak, or at least a plateau. “Pressures are mounting in the form of commodity price inflation, increased logistics costs, and labor inflation,” the investment bank wrote to clients, forecasting flat margins of roughly 11% through 2020.
Among notable cost increases, crude oil is up more than 40% over the past 12 months, while steel is up 43% over the same period.
The effect of these increases was felt broadly across the economy. Delta Air Lines DAL, +0.31% cited the “rapid increase in fuel prices” as a drag on its near-term earnings, while PepsiCo PEP, +0.49% cited price increases in both oil and aluminum.
Clorox Co. CLX, +0.33% was another of the companies that Goldman singled out for its commentary on the impact commodity prices were having on margins. According to the post-earnings conference call between analysts and the company’s management, commodity costs affected margins by 130 basis points (or 1.3 percentage points), while logistics costs had an adverse impact of 100 basis points. Colgate-Palmolive CL, +1.16% said raw material inflation had provided a headwind of 320 basis points to its gross margin in the quarter.
Wage growth is also having an impact on margins, per the Beige Book analysis. Goldman’s “wage tracker” shows growth of 2.7%, the second-highest reading since November 2008, and a wage survey it conducts averaged 3.2% in the three months of the second quarter, the highest quarterly average since the fourth quarter of 2007.
The growth is a byproduct of a labor market that continues to strengthen. In the second quarter, the unemployment rate fell to 3.8%, the lowest reading since 1969, the report read.
“Managements expect these pressures will not ease anytime soon,” the firm wrote to clients. “Looking ahead, firms are considering multiple strategies to reduce the costs, including “near-shoring” jobs and increasing investment in automation.”
Among the companies citing wage growth as a concern for margins was McDonald’s Corp. MCD, -0.67% and United Technologies Corp. UTX, +0.82% where Chief Executive Gregory Hayes said, “There really is a labor shortage here in the U.S. and in Europe. And as a result of that, we’re seeing some cost pressure that we need to deal with.”
M. Keith Waddell, the chief financial officer of staffing company Robert Half International RHI, -1.33% said that “clients somewhat reluctantly acknowledge through their words and their actions that they have to pay more.”
While few companies cited trade as an issue that was currently having an adverse impact on their results—although there are some exceptions—it was clearly a focus for corporate management teams.
“Managements are keeping a close eye on tariffs and trade discussions but have yet to initiate large-scale plans to mitigate potential effects,” the report read. “Firms emphasized their commitment to free trade and their ability to adapt should the matter begin to have a direct effect on business. Notably, firms underlined nimble supply chains and the ability to pass costs onto customers.”
Goldman’s data indicate that 53% of S&P components discussed China in their calls, including companies with limited direct exposure to the region. Companies in the consumer sector, the investment bank wrote, “mentioned China most frequently despite having only moderate revenue exposure to China (<1%) and the Asia-Pacific region (<4%) in aggregate.”
According to FactSet, with nearly 94% of S&P 500 companies having reported, components posted earnings growth of 24.86% and revenue that was up 10%. According to Charles Schwab, 84% of S&P components posted earnings that were above forecasts, while 72% reported better-than-expected revenue. Both were above their historical averages.
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