Companies set to feel profit margin squeeze despite strong demand, says Goldman Sachs

Australia’s corporate profit margins are starting to come under pressure from inflation and more hawkish central banks.

Profits margins of Australian companies are starting to come under pressure as central banks become more hawkish in their attempts to curb persistent inflation, according to Goldman Sachs.

The investment bank said while the ASX 200 has notched up 12 per cent earnings growth in the half-year reporting season, companies reported more misses than usual, with 49 per cent reporting lower-than-expected margins.

“The start of the year saw a turn of fortune for many of the beaten-up cyclical sectors and growth stocks as we saw better than expected economic data. However, stickier inflation and hawkish central banks returned to focus, and roughly half of that rebound has unwound, with defensive sectors seeing stronger results than cyclical sectors over the past month,” Goldman Sachs analyst Matthew Ross said.

Soaring input costs are beginning to peak as pandemic-fuelled supply chain crunches ease and commodity prices fall. But wages remain high amid an ongoing labour shortage, hindering the ability of some companies to undertake projects, particularly in the mining and construction sectors, Mr Ross said.

“Wet weather and floods impacted operations of some companies, as reported ‘one-off’ expenses have ticked up from low levels.

“For the most part, companies have been able to raise prices to counter cost inflation, notably the insurers and classifieds. Banks are seeing pressure on both the mortgage and the deposit markets as competition heats up, though we are yet to see any material degradation in asset quality.”

Australians have begun shifting more towards value-oriented spending in response to retail price rises. Woolworths and Coles have reported that consumers are filling their trolleys with cheaper and lower margin items — such as private label products — in an effort to stretch their dollars further in the wake of the RBA’s nine straight interest rate hikes.

Causing retailers further potential pain is the acceleration of online shopping — which has slimmer margins and erupted during the pandemic.

“Year to date trading updates have been softer, especially across the housing-related discretionary categories,” Mr Ross said.

“While retailers have cited a recovery in brick-and-mortar foot traffic, online spending appears to remain at a higher share than pre-pandemic, which may present a margin headwind for certain retailers.”

It was a different story at the top end of town, with luxury spending maintaining momentum, with demand among the wealthy for alcohol, clothes and cookware remaining resilient, Mr Ross said.

Overall, capital discipline remains with companies cautious of returning dividend payout ratios to pre-pandemic levels, Mr Ross said, and seeking to generate more investor value via one-off share buybacks instead.

“Notably, as the earnings of resources companies roll off the peak, dividends have been largely slashed. At the same time, depressed valuations have seen increased M&A activities, whereas capex intentions remain subdued versus history.”

Meanwhile, business borrowing costs have jumped sharply but Mr Ross said companies were yet to signal any stress.

“Effective interest rates are only back to levels similar to pre-pandemic levels, even as bond yields are over 100 basis points higher than 2018-19.

“Conservative leverage ratios as well as termed out debt during the low rate environment have mitigated the impacts of higher rates. While the interest burden may increasingly be a headwind to margins, it remains relatively low compared to history.”