Writ large, corporate America had a pretty profitable pandemic.
Lockdowns left shoppers burning stimulus cash on AirPods and Nintendo Switches to dilute boredom and anxiety. Supply convulsions from the war in Ukraine rerouted spending from things to pass the time to things, like groceries, that were needed to survive.
One way or another, demand for things overwhelmed the ability of workers, factories, boats and trucks to supply and ship them. And the biggest sellers of those goods—to cover their own costs, take advantage of the dislocation or both—hiked prices, leading to profit margins in 2021 and 2022 that were higher than anything seen before the pandemic.
But in 2023, the trend reversed. Margins are falling, putting pressure on executives to keep prices elevated while cutting costs, and potentially staff, to stave off investor tantrums. And as higher prices exhaust consumers, more bearish economists insist that a recession is set to start at some point between now and the end of the year.
So when companies report second-quarter earnings this week, it’ll be something of a moment of truth for the economy. Markets will get more detail on what decisions business leaders are making to replicate two years of near-fantasyland profit, amid differing views on how much more room they have to lean on further price increases. And they’ll get the first glimpse of what executives think about the prospect of a downturn.
“It keeps getting disproved by the actual numbers,” Sheraz Mian, director of research at Zacks, said of the recession forecasts. “The bears keep pushing it out to the next quarter and the next quarter. “So the biggest thing I’ll be watching out for is whether we are in the same kind of trend line we’ve been seeing the last few quarters or if things really are weakening.”
He added later: “The second half has kind of become the proving point for the bearish narrative.”
Q2 Earnings, Delta, JPMorgan
For companies in the S&P 500 index overall, FactSet forecasts a 7.2% drop in per-share profit for the second quarter, according to a report from the firm on Friday. That would still be pretty bad—the biggest percentage drop since the second quarter of 2020, when the pandemic strangled the economy and sent earnings 31.6% lower.
But for the rest of the year, for now, Wall Street expects a comeback. They see profit inching 0.3% higher in the third quarter. And for the fourth, earnings are expected to be even better, with gains of 7.8%.
The first big companies to report second-quarter results this week, among them JPMorgan Chase & Co. and Delta Air Lines, will set the tone.
See also: Megabank profits on tap after eventful Q2 of bank failures and climbing interest rates
Related: Jefferies upgrades JPMorgan Chase to buy from hold ahead of Q2 profit update
Results from Delta
DAL,
+0.41%,
which arrive on Thursday, will be a window into whether customers feel good enough about their savings and job security to still take vacations, and whether the business backdrop is solid enough to justify more corporate travel. And as fuel costs fall, Morgan Stanley analysts said the quarter would be the first since the pandemic “with no asterisks from costs and capacity.”
“While the Airlines have sounded extremely confident on demand all year, their visibility / confidence has only extended as far as the summer,” the analysts said in a research note. “However, we will now start to get our first glimpses into what the fall booking curve looks like, which is important to fend off the (second-half) demand bear case.”
As a one-stop shop for financial matters, JPMorgan’s
JPM,
+1.56%
results, due Friday, will offer an outline for the economy as a whole for that second half. Markets have rebounded. But higher interest rates have made it more difficult for customers to borrow money, the landscape for dealmaking remains cloudy, and worries have endured following the failure of a handful of banks earlier this year.
Mian said that he didn’t personally buy into the case that the economy was headed for a bigger turn south, citing strength in the labor market and household finances. But he said that the pessimists still had plenty of reasons to stay pessimistic—amid weakness in manufacturing—and that they could push their forecasts for a recession out to next year even if the earnings for 2023’s second half aren’t that bad.
Within the tech industry, large companies like Amazon.com Inc.
AMZN,
+1.30%
have helped lead a broader rebound this year, after pandemic-era digital demand dried up last year. Ivana Delevska, founder and chief investment officer of Spear Invest, said she expected that rebound to continue this year, as tech companies lap weaker trends in 2022 and businesses shake off their hesitation to spend on IT and cloud services and stampede toward AI.
“The main driver on top of easy comparisons will be AI,” she said. “This is really the biggest theme in our portfolio right now.”
Margins, AI and ‘firing people’
The results for the second quarter will come as more economists point to efforts by corporations to pad or protect profit margins—largely through price increases—as one of the primary drivers of inflation over the past year. Some economists worry that executives’ efforts to keep up with investors’ higher profit expectations will come at the expense of workers.
“Firms will offset margin pressure in the usual way, by firing people,” Ian Shepherdson, chief economist at Pantheon Macroeconomics, said in a report in April.
“The idea that margins have to fall, because they rose to unsustainable heights during the pandemic, likely will cut little ice with markets, which will reward firms taking the most aggressive action to limit the (per-share profit) hit,” he continued.
See also: More than 216,000 global tech employees have lost their jobs since the start of 2023
Within the S&P 500 index, last year’s overall profit margin—or the percentage of sales that end up as profit—came in at 12.12%, according to Dow Jones Market Data, in line with the record 12.19% recorded in 2021. Before those two years, the index had never produced a profit margin higher than 10.75%, records dating back to 1999 show.
Put another way, of the $15.45 trillion in sales that those 500 companies put up last year, $1.87 trillion went straight to profits. Every 0.1% of the S&P 500’s margins in 2023 added $1.87 billion to those businesses’ bank accounts.
Suspicions have grown over the past year that companies were using the convulsions to the economy—like 2021’s supply-chain fiasco and the war in Ukraine—to ram through price increases and keep prices higher. Costs for things like oil, crops and shipping have fallen since. Wage growth, one of the biggest costs that businesses have passed onto consumers, has slowed, and hasn’t caught up with inflation.
UBS analyst Paul Donovan, in February, noted that real wage growth—or wage growth that factors in the impacts from inflation—had been negative for 22 straight months. And he said on Friday that that growth had been “catastrophically bad.”
“Despite low unemployment, workers have not been able (to) achieve their most basic aim—maintaining living standards,” he said on Friday. “While real wage growth should turn positive as inflation falls, this argues against a structural shift of power from employers to workers.”
Efforts by executives to repeat the abnormal gains for investors through a formula of price hikes and layoffs represent a multi-pronged threat for already-struggling consumers: The prospect of losing a job, yet still having to pay up at checkout, even if weaker demand overall nudges the nation into a downturn. Some analysts also worry that the Federal Reserve’s current prescription to bring down higher prices—raising borrowing costs and engineering a slowdown in the job market, thereby weakening demand and lowering prices—will inadvertently widen economic inequality.
Rivals’ price movements
But industry bellwethers have plenty of sway to prop up prices and margins. Businesses, to some extent, have trained customers to expect higher prices. Industry consolidation has also allowed larger companies to bend some of the most basic laws of economics.
Isabella Weber, an economics professor at the University of Massachusetts Amherst, told MarketWatch in April that while mainstream theory dictates that prices reflect the laws of supply and demand, that theory doesn’t always gibe with an economy where corporate concentration has increased.
Weber said that while recessions can pull prices lower, firms that are so-called “price makers” tend not to lower their prices as much as others. Sometimes, they may even raise prices even as demand falls, she said.
“In our exploration of earnings calls we find that large firms with market power set their prices focusing on target returns with a careful eye on the price movements of their competitors,” she said over email. “Thus, prices are largely the outcomes of strategic interactions between firms.”
Weber said that for decades, economists in wealthy nations hadn’t thought much about inflation, and that when it returned last year, it was thought about only in basic terms. That is, there was too much demand, or workers had too much money, or central banks were dumping too much money into the economy. Rate hikes from the Fed, the thinking went, would raise borrowing costs, cool off investment and reverse those trends.
“Within this interpretation of inflation, there is no room for a connection between rising profits and rising prices,” she told MarketWatch. “Given this dominant mindset, pointing to the role of profits was heretic, since it implied a fundamentally different understanding of inflation.”
“Furthermore,” she continued, “it meant questioning the policies maintained by central banks around the world, most notably austerity that causes harm to working people who are already most harmed by inflation itself. So this is as much about economics as it is about politics.”
