S&P 500 profit margins touched an all-time high in the first quarter of 2021, and, if you ask analysts, they’re set to go even higher: the consensus estimate for forward 12-months profit margins indicates margins will increase to 13.1% from Q1’s 13.0% print. That’s a stark change from the decade-low margins during the first quarter of 2020.

Source: yardeni.com, Standard & Poor’s, I/B/E/S data by Refinitiv

Record margins may come as a shock given the preponderance of supply chain constraints, labor shortages, and raw material cost increases that business today are faced with. In Q1, nearly 40% of S&P 500 companies cited ‘inflation’ during their earnings conference calls.

Those problems hardly disappeared in the second quarter. The jobs market is tighter than ever, and material prices continued to rise throughout the early summer. Both a composite of regional Fed surveys for prices paid compiled by Dr. Ed Yardeni and the producer price index for intermediate goods rose to multi-decade highs in the early summer months.

Despite that, margins in Q2 are set to match the 13.0% record in Q1. The chart below, showing the year-over-year change for profit margins by sector, offers a clue as to how margins for the index have been sustained (and why they fell so much in 2020 in the first place). The Financials sector is set to increase margins from 8.6% last year, to more than 21% this year!

Here’s the catch: banks and insurers didn’t suddenly become ultra-profitable businesses. This year’s profits (and last year’s losses) are distorted by massive changes in companies’ expectations for loan losses. Accounting rules dictate that banks estimate the likelihood that customers will fail to pay back loans and then set aside enough money to cover those loans that aren’t repaid. These provisions for loan losses negatively impact net income. When COVID struck in 2020, banks set aside MASSIVE amounts of money. So massive, that the change in loan loss provisions from 2019 to 2020 accounted for about one-third of the entire S&P 500 earnings decline in 2020. Provisions are largely to blame for margins falling below 6% in the first quarter of 2020.

Here’s the other catch: thanks to huge amounts of fiscal and monetary stimulus, hardly anyone actually defaulted on their debt. Banks reserved billions of dollars for loan losses that never occurred. And since they no longer expect those losses to occur, in 2021 they get to ‘un’-provision for loan losses. Unsurprisingly, those reserve releases have been pretty massive, too, already accounting for nearly 20% of the entire earnings growth expected for the S&P 500 this year. They’ve been key to pushing margins to record highs over the last 2 quarters.

Given banks have already reversed nearly all the loan loss provisions they’re going to (and will almost certainly do so by the end of this year), that means S&P 500 companies will need to grow margins organically enough to fully offset the reserve release benefit in order to reach the 12-month consensus analyst expectation. It’s certainly a tall order. With costs on the rise, we’ll get to see just how much pricing power businesses truly have.

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