Female and male colleagues meet in an office to discuss business challenges ahead.

Lately, the choir of pessimism has gotten louder.  

The most recent chorus suggests that earnings and margin estimates are too high, and they must come down. Target’s surprise announcement to reduce its profit outlook earlier this week along with May’s inflation report seemed to confirm this narrative. Pile on top of that the looming recession warnings from high-profile executives and economists. Is this the tip of the iceberg? Are a slew of corporate profit cuts coming?   

Despite this ongoing chorus, and near-term pressures, there are reasons earnings estimates could remain at or near historic highs.   

Profitability Breakdown 

Looking back at the results from the Q1 reporting period, there wasn’t a lot of evidence that a major margin squeeze is coming. Earnings growth for the quarter was 9.5%, more than twice as good as the 4.4% consensus estimate heading into the reporting period. What’s more operating margins we also better than expected in Q1 at 16.3% vs. the 16.2% estimate. Margin dollars grew 21% year-over-year.  

A few high-profile companies reduced their profit guidance late in the earnings period, but those were concentrated in certain sectors and were company specific in many cases.   

On the other hand, higher commodity prices which didn’t really set in until later in the quarter are a concern more broadly. The appreciation of the dollar in the months since the second quarter began can also impact the large number of companies that have international exposure.   

These are real pressures that could stick around for a while. While many companies have learned how to operate more efficiently with higher costs in the past year and were able to maintain guidance when Q1 results were reported, these new factors may have an impact on Q2 margins while adjustments are made to protect profits.   

It wouldn’t be irrational for S&P 500 2022 margin expectations to contract from the 16.8% currently projected. But that doesn’t mean they will be cut dramatically. A realistic scenario could be that the 2022 operating margins return to something more closely aligned with the margin recorded of 2021 (15.8% – which compares to historic average of 14-15%).   

Graph titled Operating Margins Expanded Post-Pandemic shows near-term pressures may not reduce margins as much as anticipated with Q1 in 2015 operating at 14% going all the way to Q4 in 2022 operating at 16.9%. Source: Ally Invest, S&P CapitallQ. Data as of June 9, 2022

After the pandemic shock, operating margins for the S&P 500 quickly returned to pre-pandemic highs in 2021 and continued to expand from there. Major shifts in the economy, stimulus and a shift in corporate operating strategies helped to drive this success. While near-term pressures may result in more average margins in the quarters ahead, other factors could contribute to long-term margins that exceed the historic average.   

In the months and quarters ahead, those expecting a larger reduction in the 2022 margin picture may be disappointed.  

Inflationary Impact  

Inflation gets a bad rap, but one of the benefits can be more robust sales growth as the price of goods rise. Over the past year revenue growth has been quite strong, rising at a double-digit pace consecutively for the first time since 2006. Higher sales make it easier to absorb higher costs.  

While there are signs we may be reaching a tipping point for higher prices, this can be a good thing. Let me explain.   

At Target, excess inventory of the wrong items is causing discounting and order cancellations. Inventories in this country have been rising since Q4. The good news, besides potentially getting some good deals at Target, is that heightened levels of inventory is typically a sign that inflation is peaking. When the amount of goods for sale exceeds demand, prices can no longer go higher. Still, sales growth is likely to remain elevated, as inflation is unlikely to do a complete 180 and demand remains solid. Strong revenue growth can help offset some costs and support margins.   

There are other signs that inflation is abating, like declining shipping cost, shorter delivery times, less price and wage increases at small business. This could lead to reduced costs for some companies.    

Admittedly, inflation won’t disappear overnight, but to the extent it can cool, both companies and consumers could receive some relief.  

Realistic Margin Benefits  

A longer-term, and aa more structural supporter of margins is an increase in productivity. While the quarterly productivity report has a history of being quite volatile, over time technology driven changes could support the longevity of a higher operating margin rate. In Q1 technology spending as a percent of total capital spending by companies reached a new all-time high, led by equipment and software spending reaching levels not seen since the dot-com boom.  

Additionally, EPS estimates will have the support of buybacks. Companies heavily deployed capital in the final quarter of 2021, and that trend likely continued in Q1 with buybacks setting a new record. Cash flow has remained solid for many dividend payors and cash on balance sheets is still elevated, putting companies in a solid position to buy shares at cheaper prices.  

Bottom Line 

There are a lot of scary headlines about the potential for a looming recession and heightened levels of inflation. While things can change quickly, for the better or worse, both the consumer and corporations are supported by a solid financial foundation. 2022 margin expectations, or consensus estimates, could be reduced, but actual results are likely to be in-line or better than 2021’s 15.8% rate. Contraction in expectations does not mean there will be a contraction in actual results.    

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Headshot of Lindsey BellLindsey Bell, Ally’s chief markets & money strategist, is an award-winning investment professional with a passion for personal finance and more than 17 years of Wall Street experience. Bell’s unique ability to connect the dots between data and real life and craft bite-sized money ideas that people can use and apply stems from her deep background as an analyst, researcher and portfolio manager at organizations including J.P. Morgan and Deutsche Bank. She is known for demonstrating why and how an understanding of all things money improves a person’s finances and overall well-being. An ongoing CNBC contributor, Bell empowers consumers and investors across all walks of life and frequently shares her insights with the Wall Street Journal, Barron’s, Kiplinger’s, Forbes and Business Insider. She also serves on the board of Better Investing, a non-profit focused on investment education.

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