Forecaster of the Month: Investors and the Fed need to watch squeeze on profit margins, winning forecaster says

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The huge tax cut handed to U.S. corporations in December papered over an immense challenge that investors should pay attention to, says Richard Moody, chief economist at Regions Financial and the winner of the Forecaster of the Month contest for June.

Simply put, corporate profit margins — which have been at historically high levels — are being squeezed by higher costs as the expansion enters its ninth year. “Profit margins are past their cyclical peak,” Moody says, but few noticed because after-tax profits were fattened by the reduction in taxes paid. (Profit margins are defined here as the share of revenue that’s kept as profit.)

Companies have a choice: “They can either sit back and accept slimmer profit margins, or stand up and exercise their pricing power, or at least find out just how much pricing power they actually have,” Moody says.

How corporations respond could matter a lot for the stock market DJIA, +0.56%  , for the Federal Reserve, and for everyone else over the next couple of years.

The expansion of profit margins has been a key factor in the current high assessments of the value of owning corporate shares. If profit margins fall, those sky-high valuations could be jeopardized.

On the other hand, if companies are successful in passing along their higher costs to their customers, the Federal Reserve’s rock-solid belief that “inflation expectations are anchored” will erode quickly. Inflation could take off and the Fed would probably raise interest rates beyond what markets now expect.

Corporations are facing not only higher labor costs as the unemployment rate dips to 4%, Moody says, but also higher nonlabor costs, including materials and intermediate-input costs, interest costs, depreciation and rents.

Richard Moody, chief economist for Regions Financial

Corporations do have a third option to try to maintain high profit margins: Increase their investments in productivity-enhancing capital. They have already begun.

The rebound in capital spending was “one of the underreported stories of 2017,” Moody says. Corporations had underinvested for much of the expansion, but as the labor market has tightened and global growth firmed, the incentives mounted to invest more in capital instead of relying on cheap labor.

The rebound began before the tax cuts as a response to the steady expansion. But Moody says it’s still too early to know if the tax cuts will push corporations to invest even more. If they do, productivity growth could improve, boosting not only profits but wages and output as well.

Related: Why the Trump tax cut may not boost the economy at all

Moody remains skeptical that the economy will see more than a temporary boost to growth, at least in the short run. After 3% growth in 2018, Moody expects real growth to slow to 2.5% in 2019 and to 1.4% in 2020 as the fiscal stimulus fades and the Fed tightens.

“We’re really worried about 2020,” he said. “The significant dose of fiscal stimulus coursing through the U.S. economy will for a time offset adverse effects from trade.” If the tariff battles worsen just as the stimulus fades, the downside risks will increase.

In the June forecasting contest, Moody and senior economist Greg McAtee defeated 44 other forecasting teams to win the honor. It’s the second time Moody has won the contest. Regions Financial Corp. RF, -1.33%  is based in Birmingham, Ala.

Richard Moody’s forecast Number as reported*
ISM 58.7% 58.7%
Nonfarm payrolls 218,000 223,000
Trade deficit -$48.6 billion -$46.2 billion
Retail sales 0.4% 0.8%
Industrial production -0.1% -0.1%
Consumer price index 0.2% 0.2%
Housing starts 1.330 million 1.350 million
Durable goods orders -1.3% -0.6%
Consumer confidence 127.2 126.4
New home sales 674,000 689,000
*Subject to revision

In June, Moody and McAtee nailed three of the 10 indicators we track: the ISM manufacturing index, the consumer price index and industrial production. Three other forecasts — nonfarm payrolls, consumer confidence, and retail sales — were among the top 10 most accurate.

The runners-up in the May contest were Avery Shenfeld’s team at CIBC, Michael Thomas of Met Capital, Christophe Barraud of Market Securities, and Brian Wesbury and Bob Stein at First Trust.

The MarketWatch median consensus published in our Economic Calendar includes the predictions of the 15 forecasters who’ve earned the most points in our contest over the past 12 months, plus the forecast of the most recent winner of the monthly contest. When they differed, the MarketWatch consensus was more accurate than the closely followed Bloomberg consensus 65% of the time in 2017.

The top forecasters over the past year are Jim O’Sullivan of High Frequency Economics, Ryan Sweet of Moody’s Analytics, Christophe Barraud at Market Securities, Joerg Angelé of Raiffeisen Bank International, Michelle Girard’s team at NatWest Markets, Pat O’Hare of Briefing.com, Spencer Staples of EconAlpha, Richard Moody at Regions Financial, Jan Hatzius’s team at Goldman Sachs, Brian Wesbury and Bob Stein of First Trust, Gus Faucher at PNC Financial, Michael Feroli at J.P. Morgan Chase, Michelle Meyer’s team at Bank of America Merrill Lynch, Peter Morici of the University of Maryland (and a regular columnist for MarketWatch), and Avery Shenfeld’s team at CIBC.