Macroeconomics
TheBalanceBetweenCorporateProfitMarginsandEconomicResilience
3 mins
Our research into the U.S. economy’s sensitivity to interest rates unpacks several factors behind the economic resilience we’ve seen throughout the Fed’s hiking cycle.1 While risks around the outlook remain, the upshot is that we see an increased likelihood for the economy to avoid recession as inflation normalizes. However, as indicated in our prior research, corporate margins have been under pressure from a tighter labor market and financial conditions. Therefore, a key question for markets is whether economic growth can offset the margin pressure faced by corporates. In this note, we assess this dynamic through the corporate profit model we developed in 2020.
As we have written in prior pieces, corporate profits are a much stronger determinant of corporate spread performance than GDP growth. For example, we found a close link between corporate profit drawdowns and spread performance going back several decades. Since corporate profits can be thought of as margins multiplied by revenue (which is approximately margin multiplied by GDP as we explain below), we turn our focus to corporate margins as an intermediate step in projecting corporate profits.2
Corporate Margins Under Our Base Case of “Weakflation”
In the summer of 2022, we argued corporate margins were likely to come under pressure amidst a backdrop of labor scarcity and tighter Fed policy across a range of economic scenarios (margins were expected to decline between 0.5% and 2.5% of GDP).3 Since then, corporate profit margins have declined by roughly 1.5% of GDP, falling roughly in the middle of the anticipated range.
Figure 1 plots this recent history and updates our outlook for corporate margins with our latest set of economic assumptions. In our base case of “weakflation,” we see below-trend growth, falling but still above-target inflation, and a Fed on hold for some time before beginning a small series of cuts next year (details of the assumptions can be found in the Appendix). While a substantial adjustment in margins appears to have occurred, we continue to see some moderate pressure on margins in the quarters ahead—indeed, bargaining power has shifted towards labor and financial conditions remain tight amidst a backdrop of deglobalization. However, the key question is whether the economic resilience can offset this margin pressure.
Figure 1
Profit margins have adjusted significantly, but they may still face gradual pressure in the quarters ahead (% of GDP)…
PGIM Fixed Income, Bureau of Economic Analysis.
Given that context for margins, we subsequently multiply our margin forecast by our GDP forecast to generate a projection for corporate profits.4 Figure 2 combines our growth and margin forecasts to arrive at our profit forecast under our modal weakflation scenario. While we see some margin compression in the coming quarters, we expect the economy to be strong enough to stabilize corporate profits from here. Although our forecasted profit growth is slower than its long-term average, the level of profits still easily exceeds the pre-pandemic trend. In this particular scenario, such an outcome could be another source of resilience as corporates adjust to the higher interest-rate environment.
Figure 2
…while real corporate profits possibly stabilize and drift higher under weakflation (indexed to 100 as of Q4 2019).
PGIM Fixed Income.
A Scenario-Based Approach
However, the macro backdrop remains anything but predictable. To account for this uncertainty, we employ a scenario-based approach, which considers a range of plausible outcomes to gauge the balance of risks (Figure 3).
Figure 3
PGIM Fixed Income’s Macro Scenarios Heading into 2024
PGIM Fixed Income.
Building upon those scenarios, Figure 4 displays our projections across the scenarios along with a probability-weighted projection, which serves as a summary statistic of the balance of risks. On a probability-weighted basis, our profit forecast falls just under our base case, indicating that the risks around this outcome are skewed slightly to the downside. This skew is driven by our recession scenario to which we assign a non-trivial probability of 25% amid the risks associated with tightening monetary, fiscal, and credit conditions.
Figure 4
While a recession scenario poses a risk to profits, several upside scenarios remain (% of GDP).
PGIM Fixed Income.
However, like our base case, our probability-weighted average remains at elevated levels and points to resilience when considering the full balance of risks. While performance is likely to vary across corporate sectors, we continue to see a supportive macro backdrop for investing in corporate credit. This is especially notable considering the scope of macro risks lingering on the horizon.
Appendix—Model Drivers
PGIM Fixed Income, Federal Reserve Board, Bureau of Economic Analysis, and the Bureau of Labor Statistics.
1 Please see "Assessing the U.S. Economy’s Evolving Sensitivity to Interest Rates," for additional information.
2 We use GDP as a proxy for corporate revenues as we do not forecast the latter. Under our model, our use of GDP allows us to translate a margin and growth forecast into a corporate profit forecast.
3 “U.S. Corporate Profit Outlook: Nothing Gold Can Stay,” PGIM Fixed Income, September 2022.
4 We find real corporate profits are more closely linked to spread market performance than nominal corporate profits. If driven by inflation, nominal corporate profit growth can overstate the health of the corporate sector as such an environment likely entails higher interest rates.
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