Why business margins are a key consideration for investors

As trade woes and expected slower growth add to market volatility, investors received reminders this week to focus on the underlying fundamentals of their equity holdings.

Fundamentals provide a “reliable longer-term guide” to investing relative to responding to market volatility, said a weekly market outlook report from Richardson GMP.

One of those fundamentals is margins, which are perhaps even more important at this stage of the market cycle, with rising wage pressure, slower growth and a relatively strong U.S. dollar, it said.

For example, slower economic growth translates to slower sales growth for companies, and, if their margins contract, decelerating earnings growth would result. The situation could be exacerbated by a negative behavioural feedback loop, whereby companies collectively take actions such as cutting costs and holding off on funding new projects, which could potentially cascade into a recession, the report said.

So far, aggregate index margins remain healthy despite slower sales growth, and 53% of S&P 500 companies that reported first-quarter earnings saw margins improve year over year.

However, sales growth is expected to slow to less than 5% from 8% in 2018, with dismal forecasts for earnings growth, the report said.

Margins will also be impacted by costs—especially rising labour costs, though the pace of wage growth has so far been tempered, and productivity gains have offset higher labour costs, it said.

Large firms might be an exception. Over the last year, wage growth was most evident in large firms that employ 1,000 people or more, said CIBC economist Katherine Judge in a weekly economics report. “Smaller firms have seen more subdued acceleration in wage growth, meaning that their margins are under less pressure from wages,” she said.

Higher wages are also an economic indicator that would deter the Federal Reserve lowering interest rates “and even swing the Fed’s thinking toward another hike,” said Kevin McCreadie, CEO and CIO at AGF Management Ltd., in an online post this week.

Markets rallied this spring largely based on assumptions of a Fed rate pause or cut, as well as a potential U.S.-China trade deal, he said. Those assumptions are “far from guaranteed and may not pan out exactly as expected,” he said, referring to the recent increase in trade tensions and a Fed that must weigh various uncertainties—including wage growth—before it makes its next move.

“Stocks may climb from here, but at this stage in the earnings growth cycle, even the slightest deviation from what’s priced in could result in a setback,” McCreadie said.

That markets can be quick to price in investor assumptions underscores the importance of focusing on fundamentals. When it comes to margins, they so far remain healthy, but future earnings growth should be closely watched, along with a falling U.S. dollar or improvement to economic growth, which would help mitigate margin headwinds, the Richardson GMP report said.

In Canada, the outlook for economic improvement isn’t promising. An analysis of the average pace of growth over the last several quarters reveals “mediocre” growth is likely ahead, said chief economist Avery Shenfeld in the CIBC report.

“Remember that as you decide whether to join in when financial markets, as they inevitably do, overreact to short-term news,” he said.

Read the reports from Richardson GMP, CIBC and AGF.