Equities may face margin pressure in months ahead

With Canadian second-quarter earnings reports underway and U.S. earnings season almost over, some investment managers are lowering return expectations for the second half of this year out of concern that high margins won’t last.

Of 442 S&P 500 companies that reported Q2 earnings, 85% beat expectations and almost as many surpassed sales estimates, a report from Richardson Wealth said. These “historically elevated positive surprise rates” are even better than they look: on average, earnings beat expectations by 17% and revenue by 5%.

While year-ago numbers were somewhat depressed due to the pandemic, the Richardson authors still called the aggregate year-over-year sales growth of 28% “astonishing.” Higher sales give companies options to re-invest, acquire competitors, buy back shares or hike dividends, the report said, and they also alleviate pressure from rising costs.

But what happens to company margins when sales growth returns to more normal levels? More companies are talking about inflationary and wage pressure on quarterly calls, the report said, which means margin pressure is likely to follow.

“As sales growth slows, and if inflationary pressure remains elevated, we believe that more companies are going to see margin pressures, especially if wages begin to pick up,” the report said. “Added attention should be given to companies’ ability to pass through costs, and their sensitivity to labour cost inflation.”

In its Q3 outlook, Vanguard Investments Canada Inc. moderated its return expectations for Canadian and global equities after strong growth in the most recent quarter.

The firm’s median 10-year return expectations for Canadian equities are in the 3% to 5% range, about half a percentage point lower than the previous quarter’s estimate. This is due to the S&P/TSX Composite index’s strong Q2 performance, a report from Vanguard said, with Canadian equities growing roughly 8%.

Vanguard’s median 10-year returns for global stocks (ex-Canada, unhedged) fell to the same range, a full percentage point lower than previously forecast.

“While the ranges of our expected 10-year median returns are below recent returns, global equities are anticipated to continue to outperform most other investments and the rate of inflation,” the report said.

The Richardson authors, for their part, said it’s OK to put off worrying about smaller margins. While challenges may be coming, “for now let’s just enjoy these fat margins,” the report said.

Mark Burgess

News

Mark was the managing editor of Advisor.ca from 2017 to 2024.