Although Western academicians have begun debating if recent inflation is “greedflation” (profit-price spiral that drives inflation) instead of the traditional inflation (wage-price spiral), financial analysts, mainstream economists and the media have yet to catch up. We think this will soon change. So, we decided to write this article to explain what “greedflation” is and, more importantly, whether it explains the stickiness of current prices that may require a more severe contraction of economic activities to bring down.
Like others, we have written on the conventional reasons for today’s inflation. The supply-chain disruptions caused by the Covid-19 pandemic, the Russia-Ukraine conflict, geopolitical tensions, the “de-coupling” of the West from low-cost producer China, and the huge liquidity that was injected by almost all countries to stimulate their economies in recent years (and in the US, since the 2008 global financial crisis). All these are true.
The “new” question is the extent to which corporate greed for higher profits (through increased targets for higher profit margins) has caused inflation to be higher than it otherwise would be — in a competitive marketplace. Restricted access to inputs due to supply bottlenecks caused by the Covid pandemic, military and political conflicts or trade and financial restrictions have reduced competition and threats of new entrants. This must surely amplify the power of firms and businesses to raise their prices and profits.
The ability to raise prices and gross margins is of course possible only for firms that are “price setters”, not “price takers”. Price setters are firms that have greater market power, limited competition, and their own intellectual and proprietary rights. Price takers in contrast are firms that must accept the prevailing market price and lack any market influence. This itself is an interesting topic for discussion. We believe this is the reason for the strong performance of US equities (due to their ability to capture the economic rents and higher margins, resulting in superior earnings growth and expectation trajectory) versus those of emerging countries in general. The companies in emerging countries are at the low end of the “food chain”, doing sub-contracting, competing on costs and relying on cheap labour rather than on their R&D, intellectual property or knowledge-based workforce.
But maximising profits for firms is not greed, but instead its purpose. Economic theory tells us that companies will try to max- imise profits by producing the quantity and selling at the price where the slope of the demand curve is one. Yet, we know, no firm knows its own demand curve with certainty. At the firm micro level, companies determine how much to produce and what price to sell by taking into consideration their costs, the fact that customers will not accept daily fluctuating prices, past data and what they have budgeted. In other words, businesses do set gross margins and profit targets to fix selling prices. If one listens to talks by CEOs and financial analysts, the entire focus is on projection of higher future profits to justify higher and higher stock prices. But is this “greedflation” or simply the function of companies to maximise profits? It is this that will form the substance of much future debate by politicians, academicians, social activists and, indeed, even analysts and corporate executives.
We are data and facts-driven. So, let’s look at the financial data of recent years. Chart 1 indeed shows rising gross margins for US-listed companies over time, and especially since the onset of the pandemic. While sales have risen, profits have gone up significantly more.
Yes, this is partly because not all costs are variable. The spreading out of fixed costs over higher sales gives rise to higher gross margins. But is this also corporate greed? What about companies where profits rose despite slower sales growth, and even lower sales? Charts 2 and 3 show the gross margin changes and sales growth for different sectors of the S&P 500 companies since 2017. Ignoring the utilities and energy sectors, whose margins are driven by global commodity prices, all sectors reported rising gross margins even as sales growth fell in 2022 and 1H2023 — save for consumer staples. Why the notable exception? It is quite likely due to the fact that consumer staples are, broadly speaking, price takers. That is, they have limited pricing power in the market compared to say, consumer discretionary and information technology, sectors where gross margins continued to rise in 1H2023, even as sales declined (negative growth).
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The fact that actual profit margins are up does not in itself mean “target” profit margins were raised by firms intentionally to “cream more profits”. While this debate is beyond our scope for this article, it is, at a minimum, suffice for us to conclude that there is rising market concentration and the higher prices (today’s inflation) are NOT totally cost-push. In other words, “greedflation” is totally plausible! And almost certainly a cause of inflation today.
A major argument against corporate greed as a source for today’s inflation is that it is the consumers or buyers, not sellers, who determine prices.
Levy-Kalecki Profit and stock prices
To put this argument into perspective, I must introduce the Levy-Kalecki Profit Equation. It is an accounting identity, a truism.
It explains where total nominal profits of domestic companies (in aggregate) come from, financially. For every seller, there must be a buyer, and for every deficit, there must be a surplus. That investments (a cash outflow that is not an expense) and dividends form part of profits is simple. The reason why government fiscal deficit spending creates profits is that the government is injecting cash into the circular flows in the economy (consistent with Modern Monetary Theory). As for households, their savings would reduce profits on aggregate. A deficit on the current account (net importer) implies a net cash outflow to foreign entities, and a loss in the circular flow of income. Note the above equation refers to domestic profits, not total or national profits (for instance, it does not include profits from offshore branches).
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Thus, we can see why Corporate America was able to realise the huge profit gains over the past three years (see Chart 3). The pandemic was a blessing. It disrupted the supply chain, giving firms greater pricing power. The huge government deficit spending translated to corporate financial profits, especially since most were spent rather than saved by households. And yes, consumers were willing to pay the higher prices set by companies given the government handouts of free money and zero interest rate regime. Is this corporate greed or the consequences of public policy?
One result of the above is the consequence for the US stock market. It rose to a historical high on the back of the huge gains in corporate profits, together with almost zero interest rates. This, in turn, drew portfolio flows from abroad, further driving up stock prices. The higher and higher stock prices created a positive wealth effect that further boosted consumption and investments.
What next?
The US Federal Reserve has raised interest rates at a pace not seen previously, to ease inflation back to the 2% target. Yet, inflation is sticky, and unemployment remains stubbornly low. Many analysts have provided possible explanations. They include low labour participation rate due to demographics (ageing population and early retirements for baby boomers after the pandemic), disrupted immigration and long-Covid, even as the economy runs strong (more jobs).
We think the above argument on the possibility of “greedflation”, which is almost never mentioned, may well be the main cause. If demand or sales for products of firms are not hugely impacted, companies will try to maintain or even increase their gross margins (and prices) to realise their higher profits targets. This is evident from some of the recently announced corporate results, where profits went up despite lower sales achieved. Even more so given the elevated stock valuations in terms of high price-to-earnings multiples (PER). In housing too, the price of building materials has fallen sharply but home prices are still rising, even if sales numbers have fallen.
And because companies were enjoying higher margins and prices, and it was not a typical wage-price spiral, companies are not burdened by the high cost of labour relative to profits. Thus, despite the higher interest rates and marginally weaker demand, there is no pressure to reduce labour. This may account for the very resilient employment numbers in the US. In other words, engineering a soft landing may prove impossible if “greedflation” is indeed a cause of the present inflationary environment.
What does all this mean?
Either the Federal Reserve will have to give up its 2% inflation target, or interest rates in the US must be raised further, higher than now and for longer, until demand falls substantially (yes, a recession). Only with a sharp contraction in sales will firms then give up on their gross margin targets and focus instead on pricing above marginal costs (the firms’ supply curve). Because otherwise, the firm will not be sustainable in the downturn.
The risk with such a scenario is of course that stock prices may collapse, the wealth effect and higher unemployment will cause further contraction to private consumption, creating an avalanche.
The Minsky Moment
This article is not complete without mentioning that it is obvious from the Levy-Kalecki Profit Equation that producing profits require net expansion of the aggregate balance sheet in the macro accounting identity. For example, in the late 1990s when the US government ran a budget surplus, households and corporations must take up the slack and expand their balance sheet (spend, run down savings or raise borrowings) or demand will fall, and profits will contract. In the 2000s, it was US households and China that borrowed and invested. And since the global financial crisis of 2008, the US household sector has deleveraged, and demand came from the federal government and private sector.
The critical question now is, where is demand coming from in the future?
Both Europe and China are maxed out on debts. The US is now raising interest rates, undergoing a quantitative tightening instead of quantitative easing. The excess liquidity of the US household sector from the pandemic is largely exhausted. The saving grace is the US private sector, with its strengthened balance sheet from the huge profits generated, and households are still fairly deleveraged.
Unless there is a rise in leakage in the current account, the US will still be the profit generating centre of the world in the near term, albeit at a far lower pace.
Given the rate of expansion in the past three years with almost zero interest rates, and the likelihood that profit margins must be brought down to bring inflation back to the target levels of the Federal Reserve, the leveraged loan market that funded “zombie” firms (kept alive by low interest rates) may result in what is call the Minsky Moment — where long stretches of prosperity sow seeds of an eventual crisis. Economic instability breeds instability. It is for this elevated risk that we believe cash will be king as we have previously written.
The Malaysian Portfolio fell 0.7% last week, as shares of Insas gave back some recent gains. Last week’s losses pared total portfolio returns to 158.2% since inception. The portfolio is outperforming the benchmark FBM KLCI, which is down 20.7%, by a long, long way.
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