One key reason behind the ongoing strength in the economy has been the robustness of corporate profit margins. These still historically elevated margins have allowed companies to retain or hoard labor, and by keeping workers employed, they have also kept the economy from dipping into recession. Looking forward, however, there is growing doubt around the sustainability of those factors supporting margins, which in turn raises questions about future aggregate economic strength.

The current quarterly earnings reporting season is largely playing to the script written out over the last few decades, whereby analysts’ growth expectations diminish as the quarter progresses and are then sandbagged by just enough to produce a nice “beat” when those earnings are announced. There has been some weakness this time around in the scale of the beats, which so far have been significantly lower than in the past. The recurring phrase around these announcements by companies and analysts seems to be macro uncertainty.

What has not fit the script over the last year, however, has been the divergence between corporate revenue growth (itself a leading economic indicator) and the leading indicators of economic growth—there has historically been a strong correlation between the two. Sales growth has so far remained positive; however, had it been tracking the Conference Board’s Index LEI, it would have been expected to be much more deeply negative by this point, and even lower in the fourth quarter.

Given the relative flat-to-negative change in real retail sales, much of the strength in nominal sales can be put down to pricing power. This, along with a sharp decline in net interest costs, has been key in helping companies to maintain elevated profit margins in the face of increased employee compensation costs. Looking forward, if companies want to maintain these margins in the face of rising interest costs and less pricing power, as well as more moderate real spending growth, there will be greater pressure to seek more efficiencies in labor compensation and lighten up on headcount.

The current large gap between the NIPA measure of corporate profitability and S&P 500 profits would suggest that many smaller companies are already starting to feel these pressures. This compares to the largest ones, which have greater earnings flexibility, broader revenue streams, and higher rates of fixed-rate duration debt. The fact that in the past the S&P 500 earnings have tended to follow the NIPA earnings would suggest a note of caution when gauging expectations for growth looking into 2024.