During Q2 earnings season, all eyes are on profit margins

Corporate America's profitability depends on preserving its fat profit margins, even as its power to force through price increases ebbs.

Why it matters: Falling inflation is weakening companies' ability to justify the hefty price increases that generate sales growth — so preserving profit margins will be the key to keeping a healthy bottom line.

Be smart: Profit margins are the share of each dollar of sales that a company keeps as profit, after paying for production costs.

Catch up quick: Margins exploded to record levels amid the post-pandemic inflationary environment, as companies were able to pass along giant price increases to consumers seemingly at will.

• Margins have pulled back a bit, but they remain high by historical standards.
• Q2 results are in from roughly half of the S&P 500, and nearly 80% of companies have reported earnings above analyst forecasts — a higher level than normal, according to Refinitiv.

State of play: There's a live debate about where margins go next.

• Some believe profit margins will be squeezed further as the prices companies charge customers fail to go up as quickly as key costs like employee wages or rising interest rates.
• Others say margins could actually expand, as companies benefit from tumbling raw materials prices, which seem to be dropping faster than retail prices. (That widening difference is visible in the chart above, showing wholesale and retail price inflation.)

🗣 What they're saying: "Producer prices have fallen faster than consumer prices on both sides of the Atlantic, giving timely relief to company profit margins, and helping offset weak top-line sales ‘recession,'" analysts at brokerage firm eToro recently wrote.

• And Samuel Rines, an analyst at research firm Corbu, told the New York Times that he expects companies will be able to keep raising prices as their own costs fall, boosting margins. "The interaction of price increases and input cost deflation is powerful," he said.
• The other side: "Investors and company managements conflate nominal mismatches between top-line prices (CPI if you will) and input costs (PPI) with sustainable improvement in profits margins," argue Morgan Stanley Wealth Management analysts. "While the spread between these metrics is historically wide, such a dynamic rarely holds," they went on.

• "Wage growth is increasingly outpacing inflation growth," wrote analysts at brokerage firm Piper Sandler on Friday. "Strong real wage growth set against falling productivity & real revenue growth, means sharp downward margin pressure."

💭 Our thought bubble: When thinking about profit margins, it obviously matters what kinds of companies you're talking about.

• Industrial companies, for example, which are highly sensitive to commodities costs, might be better able to preserve margins as their raw materials inflation slows.
• But services companies, like restaurants, whose costs are heavily weighted to employee wages, could see margins get pinched hard as wage bills pull ahead of the price increases they can pass along to customers.

The bottom line: What happens to margins will be determined in a nearly invisible tug of war between companies, their suppliers and their customers over what kind of prices each of them will accept.