Productivity is Leading to Margin Expansion

A Comment on Today’s Inflation Print

Consumer prices in January rose more than expected with the headline reading up 3% y/y and the core (ex-food and energy) up 3.3% y/y. There is some noise in the numbers: January is typically a seasonally stronger month, the wildfires in California, Bird Flu impact to double-digit increases in egg prices, and a likely pull ahead of goods before tariffs get implemented (if they get implemented). On the positive side, rents and medical costs posted declines. Overall, the data is going in the wrong direction, and while a lot of the inflation we are seeing is tied to higher GDP growth, this will likely keep the Fed data dependent and less likely to ease rates anytime soon. 

It is important to keep in mind that GDP is growing above trend and is currently at 2.9% (trend is 1.5%). This is leading to upward pressure on inflation. From an investment point of view, we would prefer stronger growth with a little more inflation because it will lead to stronger earnings. In fact, 60% of S&P 500 companies have already reported four quarter results, with earnings up 12% y/y. 

A Theme with Upside Surprise

In 2025, we see the U.S. GDP growing between 2-3%. An economy with this type of growth is often coupled with mid-single-digit revenue growth and 11-12% earnings growth, both of which are a tailwind for stock prices. A recurring theme we have experienced slightly through the mid-point of fourth quarter earnings is margin expansion; companies are beating top- and bottom-line estimates while keeping costs down. We think this is a result of many factors, such as increased productivity through technology, the integration of artificial intelligence in the workplace, cost efficiencies in supply chains, and improved workforces. An encouraging sign is it is not industry-specific; this is a trend we are noticing throughout the entire economy. As technology and AI become more mainstream, we think margins can continue expanding and help companies become more efficient.

Operating income is a company’s profit after subtracting operating expenses. Operating expenses consist of naturally recurring costs incurred to run a company, such as employee salaries, marketing expenses, and costs of goods sold. Operating income divided by revenue equals operating margin; when margins increase, that is a sign that the company is effectively controlling costs while increasing revenues, likely as a result of technology, management decision making, or other factors.

Altogether, improving margins is a product of many factors, such as strong management teams, efficiencies, increased use of technology, and business synergies. Margin expansion is an attribution we look for during company analysis and believe it is a leading indicator of company performance. In a world with 2-3% GDP growth, we believe company revenues can grow 5-7% with 11-12% earnings growth – all of which equate to further margin expansion across the U.S. economy.