Yesterday I put out my latest Stay Vigilant blog. If you didn't see it, you can find it at stayvigilant.substack.com Feel free to like/share/subscribe if you haven't already

There was feedback from a long-time reader (hat tip SSS) in the comments who asked a question about company margins on a go-forward basis. The last 2 wks I have spoken about labor looking for higher wages & my gut was that this would both increase inflation & hurt margins

However, trusting your gut is one thing, running the numbers is another. I thought I would take a look at S&P 500 operating margins & compare them to CPI. While I was at it, I thought it made sense to throw in quarterly earnings & real wages to see what was driving the story

The first thing I noticed was that operating margins (white) & CPI (blue) were positively correlated. There were periods when margins would ebb & flow a bit without CPI inflation, but the bigger directional moves were captured in both

The bigger moves in both also had a smaller negative impact on earnings (yellow). Earnings are driven by both nominal sales as well as margins. Increasing the top line can hide some of the decline in margins for a company's earnings. However, sharp falls in operating margins meant sharp falls in earnings.

That brings us to real wages or the amount that goes to labor (orange). Unfortunately this time series only goes back to 2006 but it importantly captures GFC, Covid & what we see now

We can see the biggest gains to real wages come when inflation falls the most. This makes sense as real wages are nominal wages less inflation. However, this does mean the gains to labor are more from the fall in inflation than in companies giving them a bigger piece of the pie

Yet, when we see these large gains in real wages, we see a sharp fall in margins and a sharp fall in earnings. This also happened at the GFC and Covid so you might say this is spurious correlation. I can't disagree.

However, look at 2014-2015 as well. This was a smaller move not during any economic crisis. Yet, this was a period when inflation fell, real wages went higher, margins suffered & earnings came lower too

We are at a point now where we may or may not be going into a difficult economic period like GFC or Covid. Most think we are not. That's fine. What do you see on the far right of the chart though? I see real wages spiking, inflation falling & margins falling pretty sharply

Earnings have come down slightly but are yet to fall as much as one might think given the fall in margins. What will happen from here? Will margins flatten as inflation falls further? Will earnings catch down to where margins are now? Will real wages continue to climb?

The consensus is increasingly that inflation continues to fall but earnings have bottomed this quarter & will move higher. My sense is we might be a bit too sanguine on earnings right now

Stay Vigilant

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