Europe first, America next ?

The American economy may now resemble, in several respects, Europe one or two quarters ago. The question is whether the United States is escaping the economic pressures affecting Europe, or simply experiencing them with a delay.

In a previous letter, we argued that inflation can initially flatter corporate earnings. Selling prices adjust, costs catch up later, and reported revenues and operating margins can remain resilient even as the underlying economics deteriorate. More recently, we discussed the geographical divide created by higher energy prices. The United States benefits from its position as a major energy producer and exporter, while Europe, more dependent on imported energy, bears a greater share of the shock.

Putting these two observations together raises another possibility. Europe may be experiencing today what American companies will face in the coming quarters.

The difference may be one of timing rather than immunity.

The first phase of the adjustment is relatively straightforward. Higher energy, transportation, materials and financing costs put pressure on corporate profitability. Companies initially try to protect margins through pricing, procurement arrangements, hedging or cost reductions. As we have argued before, the effects take time to appear in reported accounts.

But there is a second phase, and it may be more damaging.

Higher prices reduce purchasing power. Consumers and businesses initially absorb the increases, sometimes by reducing savings, borrowing more or postponing other expenditures. Eventually, they adjust their spending. Volumes weaken, orders are deferred, and demand becomes increasingly sensitive to price.

Companies then face a difficult choice. They can continue raising prices to protect profitability, at the risk of further weakening volumes, or sacrifice margins to defend sales.

When demand eventually declines, the pressure on profitability can accelerate. Fixed operating costs cannot necessarily be reduced as quickly as revenues. Lower capacity utilization further compresses margins. A business already absorbing higher input costs may suddenly face the additional problem of declining sales.

What began as a cost problem becomes a demand problem. The demand problem then feeds back into profitability.

We can already see elements of this sequence in Europe, where input costs have been rising faster than selling prices in parts of the economy, compressing margins. The picture remains uneven, with some industries continuing to perform well, but the combination of cost and demand pressure is increasingly visible.

Here is why the United States appears to be at an earlier stage of a similar adjustment, despite its status as a net energy exporter.