The Four Gross Margin Horsemen

As Q3 2018 earnings season comes to a close, there are several important themes and trends I’m looking forward to discussing in our upcoming The Bottom-Up Economist (BUE) quarterly report. While there were many similarities between Q3 and Q2 2018, there were some subtle, but important shifts in trends. One in particular relates to corporate costs.

I’ve been discussing and documenting rising corporate costs for over a year. While the upward trend in corporate costs continued in Q3 2018, the growth rates of the major cost components fluctuated.

On its Q3 conference call, Tennant Company (TNC) addressed this earnings season’s most frequently discussed corporate costs. Management noted,

“ There are…several macro factors impacting gross margin. These take the form of higher freight costs, raw material inflation, labor shortages that periodically impact productivity and tariffs.”

I thought Tennant’s comments were a good summary of the top four gross margin headwinds most corporations are currently facing: freight, raw materials, labor, and tariffs. The effectiveness of management’s responses to these rising costs is often determining whether or not companies are winning the quarterly “beat the earnings estimate” game. Some companies have done very well by addressing rising costs in an aggressive and timely manner (probably BUE readers 🙂 ). Meanwhile, other companies waited too long to respond and fell behind the rising cost curve (probably government data readers 🙁 ).

While we’ll review the four profit margin horsemen in more detail in our upcoming BUE quarterly report, I thought I’d provide a brief summary of this quarter’s important cost trends.

First, transportation and logistics. Conventional wisdom suggests freight costs are plateauing and will possibly decline as comparisons become easier. While rate increases are expected to moderate year over year, the freight market (and truck driver availability) remains very tight. As such, unless the demand environment changes abruptly, moderation in rate increases can be expected, but not declines.

Second, raw material increases were mentioned frequently again in Q3, but similar to freight, these costs will soon lap higher increases from a year ago. Therefore, assuming there isn’t another leg up in commodity prices, the rate of increase is expected to slow in upcoming quarters.

Third, responses to tariffs increased during the quarter and are clearly inflationary. We’ll spend considerable time discussing tariffs in upcoming reports. There are literally hundreds of examples of how companies are being impacted and responding to tariffs – most are raising prices.

And finally, labor costs. Rising wages and labor availability is a growing issue and is showing no signs of slowing. Therefore, while freight and raw material inflation may be moderating, wage growth remains resilient and elevated. Thanks to a reader who recently sent the following visual example of wages increasing in real time (starting wage at distribution center increased from $15.35 to $16.85 — not bad!).

And from another reader…humorous, but also illustrates the frustration many employers are having finding qualified labor.

In summary, certain corporate costs are moderating (freight and materials), while others remain elevated and are showing signs of accelerating (labor and tariffs). With so many costs in motion, it’s becoming an increasingly tricky environment for those attempting to measure and respond to inflation. In fact, I can’t remember the time in my career when the risk of misjudging inflation has been this high for corporations, investors, and policy makers.

Policy makers are in a particularly precarious position. Underestimate inflation and risk losing the confidence of the bond market and the ability to implement future financial market bailouts (asset purchases). Overestimate inflation and risk bursting this cycle’s asset inflation boom and sending the economy into a recession. It’s quite the predicament.

The unpredictability of inflation and interest rates, in opinion, remains one of the largest risks to asset prices and the popular belief that the next bear market will be promptly rescued by another round of aggressive monetary policy (The V or the L).

While I can’t predict the future, I can see current trends in corporate costs and pricing clearly – they are rising. And if corporate costs and pricing power are on the rise, when and how will these inflationary trends reverse? Is it even possible for corporate costs (especially wages) and inflation to recede without a meaningful decline in asset prices and economic activity? It’s a good question and one I’d be asking myself if I was invested in risk assets.

Based on the valuation of my opportunity set, I remain uninterested in most small cap stocks. Until I believe I’m being adequately compensated to assume risk, I’ll be watching this market cycle age from a safe distance. With inflation and interest rates on the rise (see below), I’m becoming increasingly optimistic in future opportunity.

Short-term Treasury yield update: 3-month 2.34%, 6-month 2.52%; 12-month 2.68%; and 2-year 2.92%.