Good morning and Brr. No, not money printer goes “brr”; “brr” as in put on long johns. This week’s US cold snap has upset what had been a calm, and rather cheap, natural gas market. Gas prices were up 4 per cent at the end of last week, and futures were up by 5 per cent. Analysts say that gas prices could jump even higher over the next two weeks, especially if the cold weather disrupts supplies in Texas. Send us a nice warm email: robert.armstrong@ft.com and aiden.reiter@ft.com.
Margins
Here’s a striking chart from John Butters of FactSet (his weekly “Earnings Insight” bulletin is always full of good stuff):
S&P 500 profit margins have been high since 2021, when stimulus checks hit and post-pandemic demand was unleashed. Inflation helped, too. But the Wall Street consensus is that this year margins will surpass even the bonanza year of 2021, when margins were the highest they have been in at least 30 years. And these wider margins are a big part of the reason that the market expects double-digit earnings per share growth this year.
Is this a rational expectation? It doesn’t seem that way. The economy is strong, but slowing gently. There is evidence of price pressure in some sectors (staples, for example). Expectations for big declines in interest rates, and as such lower financing costs, have been tamped down by the Fed. There is also a chance of rising labour and input costs from the incoming administration’s tariff and immigration policies — which homebuilder shares, for example, seems to be discounting already.
The most common explanation for higher margin expectations in ‘25 is also the most common explanation for absolutely everything else about the American stock market: the magnificent seven. The business models of the megatech oligopolies have enormous operating leverage. As their revenue grows, profits rise faster still. And — the story goes — as these high-margins businesses take up a larger part of the index (currently they amount to a third of it), margins for the index will rise, too.
It is true that the Mag 7 have been a big part of the margin expansion story over the past few years. The question is whether this will be even more true over the next twelve months. This depends on two things: how much the stock prices of the Mag 7 rise (and therefore how much of the index they represent) and how much their margins increase this year. The former is hard to predict. As for the latter, here is the trend in their operating margins (I use operating margins because it is hard to see the trend in net margins, which get moved about by tax rates and other charges):
Of the seven, margins at Nvidia, Amazon, Alphabet (parent of Google) and Meta are on rising trends. Margins at Nvidia, second largest of the mags by value and the most profitable by far, is the biggest variable. For Alphabet, Meta and Microsoft, their epic spending on capital expenditures must soon show up as margin pressure, by way of depreciation expense. How all this nets out is tricky, and deserves a whole letter to itself.
The market, however, is not just expecting margin expansion from big tech. It is expecting it everywhere. Here, again from Butters, are the market net margin expectations by sector:
The market expects margin expansion in every sector except real estate! And the expected increases are meaty even in “old economy” sectors such as materials and industrials. Why would this happen?
There is a reason that margins might increase broadly, Andrew Lapthorne of Society Generale suggests: deflation in input costs.
Operating margins took a hit in 2023 when sales growth decelerated, and selling general and administrative [overhead] costs couldn’t be cut quick enough. But now SG & A costs are growing at the same pace as sales growth and cost of goods sold is below, ie, lower input costs are helping. So there’s your margin expansion.
Here is Lapthorne’s chart of the per cent growth rate of the three line items for the index, excluding the financial sector:
What is more, as Citigroup’s Scott Chronert pointed out to me, there is some hope, or even expectation, that the manufacturing/industrial/cyclical side of the economy, which has been sluggish for some years, will find a bottom and start to recover in ‘25.
But the idea of a strong economy, driven mostly by consumers and services, getting stronger still as the cyclical side picks up raises the spectre of inflation.
Ian Harnett of Absolute Strategy research offers this chart, which plots the US output gap as a percentage of GDP (that is, the amount by which the US economy is running above its sustainable growth rate, as estimated by the congressional budget office) against EBIT margins:
It makes sense that when an economy is running hot, margins should be high. When demand is high relative to supply, companies have pricing power. But given that this is so, it is hard to see inflation settling down to target or the Fed easing policy much. Harnett sums up:
At present, with the bulk of people expecting the new Trump administration to be focused on keeping nominal growth strong (in order to keep the deficit under control), this implies activity remaining above potential and therefore margins could be sustained.
The problem with this, however, is that this tends to imply greater risk of inflation being somewhat ‘sticky’, with that policy rates also falling only modestly . . . [but] a lot of the more cyclical areas of the global equity market is already discounting a synchronised economic recovery
The market expects fewer 2025 US rate cuts than it did in November. But high hopes for margin improvement reflect the view that we are still fundamentally in an easing cycle and, at the same time, the economy can remain strong or even grow stronger. But that is a hard balance. Some margin improvement is possible this year. Sales growth and tech will help. But it looks to us like the market is expecting a little too much — even before we have seen what Trump’s promise of tariffs and deportations might mean for labour and input costs.
US consumer credit
Here is the total credit card delinquency rate, across all US commercial banks:
It finally started to decline last quarter, after the Fed cut rates. Good. But that sum hides a lot of detail. What about the least financially secure borrowers? A clearer look at those is provided by auto loans made to younger (and therefore generally poorer and riskier) borrowers. The third quarter Household Debt and Credit Report from the New York Fed showed that things were improving there, too. Transitions into serious delinquency on auto loans were flat to down for 18-29 and 30-39 year olds:
A very good piece from the Kansas Fed last month gives another perspective. Using data from bank disclosures, the report shows that, while delinquency rates have risen for subprime borrowers, the banks’ own assessment of the probability of default on the loans has been stable since 2023:
Subprime delinquency rates have tended to lag banks’ default forecasts by 12-18 months, implying that delinquency rates will stabilise soon. That is great news for households, but not for those counting on multiple Fed rate cuts this year. Inflation was already above target when the stress on subprime borrowers was rising. If household finances start to improve, giving consumers more room to spend, the case for the Fed standing pat grows even stronger.
(Reiter)
One good read
Right said FRED.
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