After boosting profit margins during the Covid-19 pandemic, Canadian companies will find profits harder to come by in an economic environment that requires more capital spending, CIBC Capital Markets says.
In a report released Wednesday, CIBC deputy chief economist Benjamin Tal and senior economist Ali Jaffery warned that, with corporate profit margins “miles above their long-term average,” economic forces that fuelled profit growth in recent decades have receded.
In 2022 the aggregate profit margin of non-financial corporations in Canada was near an all-time high at almost 9%, the report said. And even after excluding the energy sector and adjusting for inflation, real profits are high.
Looking ahead, however, CIBC said higher interest rates, slowing demand and lower labour productivity will squeeze margins. Firms will need to spend more to increase productivity. The good news is they’re largely equipped to do so, as high profit margins in recent years led to firms accumulating “a mountain of cash.”
Capital spending has been a “serial disappointment” for years as easy profit made firms less inclined to invest, the report said. “With the era of easy profit coming to an end, a growing number of firms will find that capital spending becomes a necessity as opposed to an option.”
Margins surged during the pent-up demand of the Covid-19 pandemic, CIBC said, when government stimulus supported spending and corporate pricing power remained strong. With supply chain disruptions out of the way, margins have declined, and CIBC expects that to continue as higher rates and a weaker economy squeeze businesses.
To protect margins, businesses will try to cut costs with slower wage gains, layoffs and increased productivity, but CIBC expects “only limited success here due to the fresh memory of the struggle to re-hire after the pandemic.”
The authors looked at economic developments over the last three decades to explain the growth of profit margins and what happens next. The shift in corporate Canada’s makeup away from manufacturing and energy to higher-margin sectors such as real estate, education and health services was only a small contributor, the report found, pointing instead to global macro forces such as globalization, declining labour costs and technological innovation.
In the decade leading up to the global financial crisis, firms’ investment in new technology led to increased labour productivity while employment remained strong. Leading firms were able to mark up product prices, particularly during the period from China’s entry into the World Trade Organization in 2001 until around 2013, CIBC said.
Labour’s share of income remained low in the period after the financial crisis until the Covid-19 pandemic, supporting high profits. “However, underneath the hood, an unfavorable balance has been brewing,” the report said. Productivity growth declined and real wage growth increased slightly as boomers retired, though labour’s bargaining power remained weak.
CIBC said the pandemic provided a brief window for firms to raise prices again: markups jumped in 2021 to the highest level since 2010.
“During the post-pandemic and high inflation years of 2021 and 2022, weak real wage growth, a strong cyclical rebound and a jump in markups mostly explain the surge in profit margins,” the report said.
Looking ahead, however, CIBC said higher interest rates, slowing demand and lower labour productivity will squeeze margins. More retiring boomers will push up wages, while geopolitical tensions and changes to global supply chains will put pressure on productivity and markups.
“Pre-Covid profit conditions should not be extrapolated forward, and earning expectations will need to take into account a changing environment,” it said.