What does slower inflation mean for sales growth?
As illustrated in the chart above, consumer inflation and corporate sales growth tend to track with each other. Company sales figures are reported in nominal terms, so a general trend upward in prices will typically contribute to a corresponding uptrend in revenue growth. The same dynamic is evident during a period of disinflation, as has been the case for much of the period since the 12-month rate of change in the consumer price index peaked in mid-2022. If that relationship holds true, the sharp decline in inflation is likely to show up in the form of weaker top-line revenue growth for U.S. companies broadly. This has further implications for corporate profit margins and earnings to varying degrees. All else being equal, a decline in top-line growth would be expected to flow through to bottom-line growth as well.
In recent years, companies had been able to exert substantial pricing power on their customers, enabled by strong demand and fueled by elevated wage growth and a considerable household savings stockpile accumulated since 2020. Strong demand allowed companies to increase prices, boost revenue growth, and defend their margins despite a drag from higher labor and material costs. However, those trends appear to be breaking down, as sales growth is slowing. That impact is also being felt on corporate bottom lines. Q2 is expected to bring the third consecutive quarter of negative year-on-year earnings growth for the S&P 500, with profit margins also shrinking. Despite weaker fundamentals and more limited pricing power, equities have continued to climb the wall of worry this year. Whether that can continue will likely depend on the evolution of Fed policy and the relative strength of the economy, including greater clarity around the landing, whether hard (recession) or soft. Under either circumstance, peak revenue growth for the current cycle has almost certainly passed, and future earnings growth will be more dependent on cost cutting to augment more limited top-line growth.
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