After raising prices sharply, corporate profits get squeezed as inflation eases

Many analysts believe margins hit bottom in the second quarter, and they're forecasting a recovery in the second half.

After enjoying a strong run where they could keep raising prices to boost their profits, companies are now stuck in a vice. On one end, revenue is under pressure as the global economy remains fragile. On the other, companies are having to pay higher wages for workers, among other costs.

Caught in the middle are corporate profit margins, which measure how much profit companies make on each $1 of revenue.

Consider Tesla, which reported not only stronger profit but also better revenue for the spring than analysts expected. Its stock nevertheless tumbled nearly 10% following the report, as some investors focused on its falling profit margins.

The electric vehicle maker made an operating profit of $9.60 off every $100 in revenue from April through June. That was down from $11.40 three months earlier and from $14.60 a year earlier.

Not only did Tesla cut prices on some of its models to drive sales, which pressured revenue, but it also had higher costs driven by projects like its Cybertruck and an artificial intelligence initiative.

Altogether, companies in the S&P 500 likely earned $111 in net profit for every $1,000 in revenue during the spring, according to FactSet. That would be the weakest level since the end of 2020 when the economy was still coming out of the crater created by the coronavirus pandemic.

The threat to the stock market is that margins could remain pressured. That would cap profits, which are already on track for a third straight quarter of year-over-year declines.

Many analysts believe margins hit bottom in the second quarter, and they're forecasting a recovery in the second half. Others are less optimistic.

Lisa Shalett, chief investment officer at Morgan Stanley Wealth Management, sees a risk of what she calls "unsustainable margins" leading to disappointment in the next six to nine months.

Throughout history, there's been a pattern of analysts, investors and CEOs thinking the 'temporary pricing power' created by mismatches between high consumer inflation and input costs for companies are actually sustainable improvements in profit margins, according to Shalett.

Strategists at BlackRock Investment Institute, meanwhile, point to high labour costs eating into profit margins in the second half. Average hourly earnings for workers were 4.4% higher in June than a year before. That was a bigger increase than the 3% for overall consumer price inflation, which can offer a crude look at how much companies are raising their prices.

"We expect a squeeze on corporate margins if inflation stays high and an even larger squeeze if it falls," strategists at BlackRock Investment Institute said.

If inflation were to fall, it would imply companies are having a tougher time raising prices for their customers and would dent revenue for companies. Or it could mean the economy is heading for a recession, which would also hurt revenue.