Profit Margins Are A Reason For Concern: Rates Cuts

From Tim Murray, Capital Markets Strategist, Multi‑Asset Division at T. Rowe Price  

The U.S. Federal Reserve now appears almost certain to begin a rate‑cutting cycle in September. Not surprisingly, global stock markets have responded positively to this news. However, investors should understand that rate‑cutting cycles are not all the same.

Historically, cutting cycles accompanied by “soft landings” for the U.S. economy have tended to be very good for stock markets. But cycles with recessions have tended to be bad for them¹.

This is why the health of the U.S. labor market is so important right now. If higher interest rates have cooled inflation but ultimately lead to a spike in unemployment, investor enthusiasm over Fed cuts is likely to be short‑lived. 

U.S. labor markets appear to be normalizing

The July report on non‑farm payrolls, released on August 2, proved weaker than expected, triggering a sharp, but brief, sell‑off in the stock market.

However, a closer examination of the July data revealed a relatively benign picture. Job creation has slowed over the past three years, but only toward a growth rate that is more in line with the longer‑term average. The pace of this slowdown also appears to be flattening out.

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Weekly unemployment claims paint a similar picture. Claims have increased steadily so far in 2024 but are still low relative to longer‑term history. This supports the case that U.S. labor markets are simply normalizing, rather than flashing a recession warning.

Profit margins are a reason for concern

However, there are still reasons to be concerned. One area that bears watching are profit margins for smaller companies. Small companies typically carry higher debt burdens than larger firms, so higher interest rates have taken a proportionally larger bite out of their profits. When profit margins shrink to low or even negative levels, companies are often forced to lay off workers.

Overall, profit margins for U.S. publicly listed companies appear healthy and stable. But profit margins for smaller companies, as measured by the S&P 600 Index, have been deteriorating for more than two years².

This is potentially bad news for the labor market because small businesses account for the majority of U.S. jobs. It is also why there is an urgent need for Fed policymakers to cut rates even though inflation hasn’t yet returned to their 2% target.