Could falling inflation trigger layoffs and a recession? Hint: Watch corporate profits

Could the big inflation slowdown trigger a surge in layoffs and recession this year?

On its face, the idea may sound laughable. Easing -- though still high -- inflation has been a relief to consumers. And it has spurred Federal Reserve officials to signal they’re probably done hiking interest rates and tentatively expect to cut them three times in 2024. That has propelled the stock market to new highs.

But some economists reckon the drop-off in price increases, combined with softening consumer demand, will narrow corporate profit margins. And that could prompt more companies to lay off workers and spark a mild downturn.

“As inflation declines, so does pricing power,” says Kathy Bostjancic, chief economist of Nationwide, referring to a company's ability to hike prices without losing a significant number of customers. Reduced pricing power, she says, crimps profit margins, a holy grail on Wall Street.

Companies grappling with an earnings squeeze will likely shave expenses, Bostjancic says. “The only way to (significantly) cut costs is to reduce employment,” she says.

Bostjancic notes that falling profit margins were accompanied by a rising unemployment rate in all of the past four recessions, according to figures from Nationwide and Bloomberg.

Joseph LaVorgna, chief economist of SMBC Nikko Securities, says compressed margins would be "a big negative for both the jobs market" and stocks.

Although their view that dwindling margins will help set off a modest economic slump isn't shared by most forecasters, corporate earnings have sent some worrisome signals the past year.

Is the economy doing well or not?

For now, the economy is on surprisingly solid footing despite high interest rates and inflation. On Friday, the S&P 500 stock index hit a record and a report showed consumer sentiment rebounding close to its historical average.

Despite high borrowing costs and prices, consumer spending has been remarkably resilient and most economists no longer forecast a recession in 2024, though growth is projected to slow.

Meanwhile, job cuts overall have remained historically low. Companies have been loath to lose employees after two years of COVID-related labor shortages. Initial applications for unemployment benefits, a reliable gauge of layoffs, fell to a 16-month low the week ending January 13.

What major companies are laying off employees?

But an array of household names recently announced layoffs, including Macy’s, Google, Wayfair, Amazon, Citigroup and Universal Music. Some economists worry the list could grow if corporate bottom lines are pinched in the months ahead.

Are S&P 500 companies good?

Just 10% of S&P 500 companies have reported fourth-quarter earnings, according to FactSet, which estimates margins for the entire earnings season will average 10.9%. That would be the lowest since late 2020.

Profits were leaping when the U.S. emerged from the COVID-induced recession. Americans armed with cash from stimulus checks and hunkering down at home went on spending sprees. The binges, along with pandemic-related supply chain bottlenecks, sent inflation to a 40-year high of 9.1% in June 2022, according to the Consumer Price Index. Inflation has since dropped to 3.4%, still well above the Fed's 2% target.

In 2021, as prices began vaulting higher, consumers generally were willing to pay them. Many companies jacked up the charges by more than what was required to cover their rising costs, and that fattened their profit margins. S&P 500 margins peaked at 13% in the spring of 2022.

But by late 2022 and 2023, more Americans began resisting outsize price increases. Companies, meanwhile, were still coping with higher wholesale costs and borrowing expenses due to the Fed’s rate hikes. From late 2022 through fall 2023, S&P 500 earnings fell each quarter from the year-earlier period, a streak known as an earnings recession.

That ended in the third quarter of 2023. But among the 10% of companies reporting fourth-quarter earnings so far, profits are down 1.7%. Bostjancic frets the earnings recession may have foreshadowed a more dramatic hit to profits in 2024 because it would come just as customer demand is flagging.

Others are more sanguine.

FactSet expects margins to rebound in the first half of this year. And several corporate finance and stock experts say it’s unlikely shrinking margins will lead to widespread layoffs.

Many companies aren’t fixated on profit margins and are more concerned with their earnings, revenue and market share, says Sandeep Dahiya, a professor of entrepreneurship who focuses on corporate finance at Georgetown University’s McDonough School of Business. For now, he says, he doesn't expect a surge in layoffs.

“There’s a lot of waiting and watching” by large companies to see if both inflation and interest rates will come down, Dahiya says.

Are supply chains going back to normal?

Ed Clissold, chief U.S. strategist for Ned Davis Research, says companies have been boosting their profit margins recently by reducing shipping costs as supply chain snarls have resolved. He expects that to continue this year.

“A falling inflation rate is not going to trigger a recession,” he says.

Bostjancic agrees that manufacturers are expanding their margins by cutting shipping costs. But she worries that service companies such as restaurants and retailers, which make up 80% of the economy, will be saddled with declining sales at the same time that employee wages – their main expense – continue to rise at a slowing but still robust pace.

What is the average wage growth rate?

Average hourly pay grew 4.1% annually in December, up from 4% the previous month, Labor Department figures show. Meanwhile, Bostjancic expects consumer spending to soften because of the delayed effects of Fed rate hikes, record credit card delinquencies, and the depletion of pandemic-related savings and demand. Small- and midsize companies in particular could feel the strain, she says.

Bostjancic expects 1.6 million job losses this year, pushing the unemployment rate from 3.7% to 4.8%.

“Companies are likely to come under pressure and they’ll need to shed labor,” LaVorgna says.

There's a caveat.

Productivity growth - or output per worker - has been unusually strong the past year due to technology and other improvements.

If that continues, Bostjancic says, it could allow many businesses to keep raising wages without enduring a significant blow to their earnings and cutting jobs.