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Following the pandemic, most consumers face soaring living costs, job uncertainty and declining home and/or portfolio values. It’s clear that our economy is confronting a big headwind.
Authored by: Christine Tan, Portfolio Manager, and Pedro Cadavid, Senior Portfolio Analyst, SLGI Asset Management Inc.
Pent-up pandemic demand has impacted Canada’s economy. Looking back, consumers emerged from over a year of lockdowns with big savings. During that time, they also consumed endless headlines on how supply chain problems were driving up inflation. What happened after that? Those same consumers grudgingly paid up for all the experiences, and goods, that they had dearly missed.
In turn, this means that companies catering to these insatiable consumers were able to pass through higher costs, and in many cases, increase their profit margins to above historical levels. Let’s take a closer look at the impact this has had on many companies.
Let’s illustrate with a hypothetical widget manufacturer called W Inc.
Scenario BEFORE lockdowns |
$100 widget sale price - $20 materials cost - $20 transport - $20 wages - $20 sales & marketing = $20 pre-tax profit |
| Pre-tax profit margin = ($20/$100) = 20% |
W then announces it must increase its widget price by 10% because of a 10% increase in material and transportation costs. And some of the other costs have also risen.
Scenario AFTER lockdowns |
$110 widget sale price - $22 materials - $22 transport - $20.80 wages (4% increase in wages) - $20.80 sales & marketing (reflecting wages increase) = $24.40 pre-tax profit |
| Pre-tax profit margin = ($24.4/$110)) = 22.2% |
This repricing example above shows how earnings margins could rise above pre-pandemic levels despite severe cost inflation. In addition, inflation also provided nominal earnings growth. Let’s say W sells the same number of widgets at $110 as in the prior year for $100. Company sales would appear to have risen by 10% while pre-tax profits looked like they grew 22% year-over-year ($24.40 vs $20) even though the actual demand for widgets was unchanged. This raises the question – over the past few quarters was earnings growth that resilient or was inflation boosting numbers?
Where are we today?
Nearly three years after the pandemic, Canadian consumers are facing soaring living costs, declining home and/or portfolio values, and more job uncertainty with a rising risk of recession. The Bank of Canada’s Q3 Consumer Survey showed that 80% of Canadians are reacting to inflation by buying less, seeking discounts, or restricting purchases to only necessities. This is a big headwind for our consumption-based economy. There are similar weakening trends in the U.S., but its labour market is still tighter than Canada’s.
The year 2022 has been mainly about higher interest rates causing stock valuations to drop. We saw a reversal of the prior two years of TINA (“there is no alternative”), when markets were willing to pay high stock multiples in the wake of depressed bond yields near zero. We believe next year’s focus will be on earnings as margins normalize on weaker consumer demand without the pricing tailwind. While earnings expectations for 2023 have been revised downwards several times, consensus estimates still point to 7% and 3% earnings growth for the S&P500 and TSX, respectively. We believe these estimates to be optimistic given heightened recession risks and we expect more downside risk. But it’s not all doom and gloom. We see company balance sheets remaining strong. Management teams sound cautiously optimistic looking beyond the next couple of quarters, and consumers still have savings.
Recession risks
While we think the chances of a recession are high, it’s not a certainty. And if there is a recession, we don’t believe it will be severe. So, we are taking this opportunity to own bonds at an attractive yield and to hold quality stocks trading at a more reasonable (although not cheap) valuation, while keeping a close watch on the direction the economy and company earnings.
The views expressed in this article are those of the authors and are subject to change at any time. Views expressed regarding a particular company, security, industry or market sector should not be considered an indication of trading intent of any mutual funds managed by SLGI Asset Management Inc. These views are not to be considered as investment advice nor should they be considered a recommendation to buy or sell. Information contained in this article has been compiled from sources believed to be reliable, but no representation or warranty, express or implied, is made with respect to its timeliness or accuracy.
