Goldman Warns "Margin Contraction Is Unlikely Without A Recession"

With Q3 earnings season winding down, it is safe to say that even though 3Q earnings came in sold, rising about 26% Y/Y, they are providing little support for the market. Companies that beat on both EPS and sales have seen scant rewards, while companies that missed have been viciously punished. The reason for this is Wall Street's growing obsession with "peak earnings" which, in a time of stable revenues, means rising concerns about profit margins. Not surprisingly, Goldman's chief equity strategist David Kostin dedicated his last Weekly Kickstart note to what companies laid out as the three main sources of margin pressure going into 2019, which were as follows: (1) increased tariff rates, (2) a tight labor market, and (3) rising debt costs.

Overnight, in a new note from David Kostin in which he explained why Goldman now expects decelerating EPS growth in the next two years, noting that he now "expects S&P 500 EPS growth will decelerate from 23% in 2018 to 6% in 2019 and 4% in 2020"...

... he focuses on the same, key variable, namely profit margins, and while he expects aggregate profit margins will plateau at 11.2% in 2019 and 2020, he - like Morgan Stanley last month - makes a notable warning: "History suggests that margin contraction is unlikely without a recession or negative sales growth".

Which is not to say that Goldman is forecasting a recession yet: the bank's baseline 2019 forecast is for roughly 2% real US GDP growth, 2% inflation, and sales growth of 5%, "which should support margin expansion." However, Kostin writes that "this outlook is less favorable the further into the economic cycle we move, as a tighter labor market and slowing growth will eventually weigh on profitability".

So what are the key risks of margin contraction, and my implication, recession?

According to Kostin, among the most imminent risks to profit margins is rising wages:

In October, the unemployment rate was 3.7% and average hourly earnings growth surprised to the upside (+3.1% year/year, the highest this cycle). Our Wage Survey Leading Indicator points to more wage pressure in the near term. Our previous analysis showed 13% of S&P 500 revenues are devoted to labor. Historically when labor costs are rising more than inflation (i.e., companies are unable to pass on costs to consumers), S&P 500 margins have contracted. We estimate that every 1 pp increase in labor cost inflation lowers S&P 500 EPS by roughly 0.8% ($1).

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Gary Anderson 2 months ago Contributor's comment

It is absurd to think that paying people more would cause a recession. The attempt to curtail wages causes recessions. Pay people more and they will buy more. Stop their wage growth and they cannot meet their credit obligations.