Yet another post inspired by an article in The Economist. Here’s an excerpt: 

“To the ears of many, ‘pricing power’ is something of a dirty term. For left-wingers it conjures up images of greedy corporations abusing their market dominance to charge more. For economists it raises the spectre of sticky inflation as companies ratchet up prices to cover higher costs. But from another perspective, pricing power is less of a problem: it enables firms to withstand the kind of inflationary pressures that they are now experiencing. In so doing, it serves as a shock absorber for the economy, forestalling the risk of a recession.” - Vast corporate profits are delaying an American recession: Strong pricing power for firms makes the economy more resilient. The Economist August 30, 2022

Highlights:

  • Post-tax corporate profits reached 12.1% of GDP in the second quarter of 2022, their highest since at least the 1940s.

  • When faced with lower profits, companies seek to cut costs and may do so by firing workers. When sufficient numbers do this, it becomes a drag on the rest of the economy.

  • Companies with comfortable profit margins are more resilient to cost-cutting pressures. That’s a win for workers and the economy.

  • Why are companies doing so well? Unsurprisingly, energy firms have led the pack, benefiting from the surge in oil and gas prices.  However, excluding energy companies, revenues for the S&P 500 were still up by 9% compared to a year ago.

  • The robustness of profits over the past year is down to something fairly basic: consumer demand, which has been fuelled in part by several rounds of stimulus. Also, well-managed companies that build margins for a rainy day.

  • Pessimism is growing though, as the Federal Reserve raises interest rates to fight inflation. Some companies have already started to cut back capital-spending plans, which could impact hiring as well.

  • But current cost-cutting is being done from a position of strength. Even if the Fed decides to induce a recession to combat inflation, the resilience of profit margins may allow the economy to bounce back fairly quickly.

Take-away:

People and companies enter transactions with potential profit in mind, meaning they expect to get more than they give, i.e., they expect the potential benefits will be worth more to them than the anticipated costs. Society would not exist without the profit motive. Large profits are not bad in themselves, unless they are persistently so. (At least as a general rule - as always, the devil’s in the details!)