For folks watching the markets, the dominant risk of 2021 has been inflation.

The reason is very simple: Inflation means higher costs.

In recent months, when a big corporate executive sounds off on an earnings call, appears on TV, or gets quoted in a press release, they’ll flag inflationary forces like rising raw material and labor costs as pressuring profit margins.1

But reported Q3 financial results have not reflected what was widely expected to be a sharp decline in profit margins.

Record-high profit margins

“Analysts were expecting Q3 margins to be well below Q2, but that’s not what happened,“ Nick Colas, co-founder of DataTrek Research, wrote on Monday.

According to FactSet data cited by Colas, the net profit margin for the S&P 500 during Q3 is tracking at 12.9%. This is well above the five-year average of 10.9% and just barely below the record high of 13.1% in Q2.

Margins have held up so well that Wall Street’s most prominent strategists are going out of their way to acknowledge the surprise.

“Although rising cost pressures due to labor shortages, commodities inflation, and supply chain disruptions have warranted investor concerns, companies are weathering these challenges better than expected,” David Kostin, chief U.S. equity strategy at Goldman Sachs, wrote in a note to clients last week.

“Despite a record high rate of change in input costs, companies were able to manage margins with impunity,” Sean Darby, chief global equity strategist at Jefferies, wrote on Monday. “On this basis we were premature to call a peak in ‘margins’. Mea Culpa.“

What happened?

Colas, who was among a handful of experts who’ve been predicting this positive surprise, says robust margins are “the result of effective corporate management working to offset continued macro and micro uncertainty.“2

Efforts like cost cuts, tech upgrades, and working-from-home surely helped a lot of companies benefit from operating leverage, or the degree to which a company can increase sales without increasing costs.

The customers are paying for it

Another big factor bolstering profit margins: Companies raised prices and made their customer pay for higher costs.

“Earnings calls show managements are leveraging pricing power to preserve margins,“ Kostin wrote.

Customers may recognize what’s going on and they might not like it. But if they can still afford it, they’ll pay.

Recall this anecdote from McDonald’s CFO Kevin Ozan after the company raised menu prices by 6% (via The Transcript): “We haven't seen, I’ll say, any more resistance to our price increases than we've seen historically… The 6% has been pretty well received by customers."

McDonald’s wasn’t alone. As I mentioned two weeks ago, Procter & Gamble, Chipotle Mexican Grill, and Unilever are among companies flexing their pricing power. According to Goldman’s Kostin, Domino’s Pizza and Kimberly-Clark are among a slew of companies getting customers to pay for inflation.

This is occurring across industries, not just consumer-facing ones.

It’s not over

Savita Subramanian, Bank of America’s head of U.S. equity strategy, did a deep dive into quarterly earnings calls and observed that there were far more mentions about pricing than there were about labor.

According to her analysis, mentions of pricing serves as a proxy for pricing power while mentions of labor serve as a proxy for rising costs. And so, a widening spread between mentions of pricing and labor is thought to signal rising profit margins.

Indeed, the chart below from Subramanian illustrates just how tight that correlation is.

And this trend could continue in the coming quarters.

“Many companies touted their pricing power and planned further pricing increases in the coming months,” Subramanian said, adding that analysts forecasting significant margin deterioration could be proven wrong again.

What to make of all of this

This is not a trend that buyers of stuff will be thrilled about. (Though, workers should use it as leverage when asking for a raise.)

However, it’s the kind of thing that should keep investors bullish. It’s why it’s dangerous to underestimate corporate America. Companies will go above (and sometimes beyond) to meet or beat expectations.

Here’s some other stuff I’ve written recently:

• Most of the time, most people expect stocks to be lower in the next 12 months. That means people are wrong most of the time. (Link)

• When people congratulated Jeff Bezos on a great quarter, he’d be thankful. But he had other thoughts. (Link)

• The October jobs report confirmed companies were hiring. It also confirmed a lot of people were going back to the office. (Link)

• Underestimating corporate America is “dangerous.” BofA explains why. (Link)