Sticky Margins & Entrenched Inflation Remain Continued Headwind For Risk Assets

Authored by Simon White, Bloomberg Markets Live reporter and macro strategist,

Company margins have come down in recent months but remain high versus pre-pandemic levels. This will contribute to entrenching inflation and thus keep liquidity conditions tight, posing a continued headwind for risk assets.

We got the other side of the inflation story last week, with the release of PPI. This gave us valuable information on a key element for understanding inflation’s path in the current regime: profit margins.

Initially it was the price of commodities that rose, pushing PPI higher than CPI. This allowed firms to increase their margins. But as price rises have begun to filter across the economy, pushing CPI higher, consumers have become increasingly squeezed. As PPI is now falling relative to CPI, margins are beginning to adjust lower.

But after one of the largest rises ever seen as firms took advantage of the unique circumstances of the pandemic, they may not fall back to pre-pandemic levels, helping keep inflation sticky.

The BLS attempts to infer company margins in the PPI report. PPI measures prices received for goods and services for non-retail firms. A wholesaler’s value-add comes from the service it provides to its customers, e.g. selling and promoting, transporting and providing market information. But this is not directly measurable for the retail sector.

According to the BLS measures, most types of companies’ margins are falling on an annual basis, with the businesses that saw the largest rise in margins now seeing the biggest falls, such as vehicle dealers and freight transportation.

But compared to where they were before the pandemic, margins are still high, and this is supporting CPI, especially the significant services component. As the chart shows, there has been no relief in inflationary pressures here.

While CPI is currently in a downtrend, this may reverse sooner than the market expects due to a global cyclical upturn. Sticky margins would further keep consumer inflation from continuing to fall — certainly down to the 2.5% expected by inflation-fixing swaps by June.

This will ensure risk assets continue to face resistance from poor liquidity conditions. Despite some discussion of green shoots for global liquidity, it is still too early to sound the all clear.