June 02, 2011 11:44 AM
By Tobias Levkovich, Chief US Equity Strategist, Citi
The financial media is full of pundits worrying that corporate profit margins will be hurt by higher commodity prices even as raw material prices and margins move directionally in tandem as opposed to an inverted fashion as is often expressed incorrectly. The reasons actually are relatively simple and fully reconcilable.
Higher global demand drives commodity prices up and aggregated profits just get distributed differently as energy companies, for example, make more money and retailers make a little less. Steel producers mint profits and car manufacturers' margins get restrained. But, if global demand stalls, commodity prices decline and every company's margins slide as well since broad demand weakens.
Labor is by far the biggest component of corporate cost in developed countries that have large service industries, accounting for as much as 60%-65% of corporate expenses relative to maybe 10% or 12% for commodities. And, as unemployment dips alongside job growth, the labor component of cost will edge up towards that 65% level, with some impact on margins.
This data is available to almost anyone who wants to seek it out, yet the debate around the impact of commodity prices rages on, suggesting that analytical insight is being drowned out by opinion.
NOTE: This post is adapted from a Citi North America Equity Strategy note, "Tuesday Tidings: Insight Trading," published on May 27, 2011.