Macro views
Macro views

Corporate earnings: Growth clouds have arrived

March 9, 2023 | 6 min read
Garrett Roche, CFA, FRM
Global Market Strategist

There is growing consensus amongst economists and strategists that an economic recession in the U.S. will likely occur within the next 6-18 months. With the effect of higher interest rates yet to be fully felt by the real economy, and consumer budgets stretched from inflation, a broad economic recession would have a serious impact on the already shaky footing of risk assets. While many macro signals have already triggered current recessionary conditions in some pockets of the economy, the 4Q22 inversion of the 3m10y Treasury yield curve (a historically strong indicator that a broad economic recession is probable within the year) means that investors need to prepare portfolios for the volatile period that is likely ahead.

The cost, and benefit, of the inflation surge

During the post-COVID recovery, companies faced massive demand from consumers. Released into an economy that had experienced lockdowns and substantial supply-chain disruptions, the combination of pent-up demand (supported by historically high excess savings derived from fiscal pandemic relief) and COVID-induced restricted supply spurred both inflation and corporate profits to historically high levels.

For corporations, the inflation surge was generally seen as a tailwind. Inventories, which had been acquired at lower costs before the surge in demand, were now selling at exceedingly higher prices. However, while sales of lower cost inventory at higher prices will always be profitable, the current scenario only provides companies with a one-off, temporary boost to gross margins. In 2022, the result was expanding margins on the back of positive operating leverage, with many companies able to report strong profitability.

Entering 2023, however, with inflation beginning to abate and the lower-cost inventory bump to margins long since digested, consumer prices remain high for many essential goods and services. The same companies that benefitted from low-cost inventories and high prices, are facing inventory replacement at more current, higher prices, and consumers who have insufficient savings to tolerate higher passed-through prices. As inflation slows throughout 2023, this backdrop will challenge corporate profitability and will very likely lead to a recession in corporate earnings.

Consumer Price Index (CPI) and corporate earnings
2015–present

Line graph of the consumer price index (CPI) corporate earnings from 2015-2023

  Source: Bureau of Labor Statistics, S&P Dow Jones, Bloomberg, Principal Asset Management. Data as of March 6, 2023.

A “soft landing” to the rescue?

So-called economic “soft-landings” arise when the U.S. Federal Reserve (Fed) hikes rates to address inflation concerns but manages to not cause a recession. Soft landings are rare occurrences—only four since 1965—and those occurred when the Fed hiked rates while there was benign food and energy inflation, below 5%. During instances when the Fed began hiking rates and food and energy inflation was above 5%, as is the case today, that environment often delivered an economic recession—a “hard- landing.”

The combination of higher food and energy prices, coupled with Fed rate hikes, most often fosters recessionary conditions. This is because during times of stress, consumers can often handle the rising cost of staples by tapping credit. However, once the Fed begins raising credit costs as well, consumption becomes constrained to a point where an economic recession becomes more certainly assured.

Historically, when ISM New Orders (manufacturing) falls to, or below, a reading of 47 (currently 47.0), and year-on-year New Private Building Permits (housing) contract by 20% or more (currently -27.3%), both non-consumer cyclical industries are already signaling recessionary conditions. This leaves the consumer as the only remaining significant economic engine yet to experience outright recession—and in 2023, pressure is mounting. Real consumption (PCE) is still experiencing annual growth of 2.4%, but this had been waning with month over month declines since August 2022. With January’s surprise upside reading, all eyes will continue to be on consumption readings in the coming months to see if January was an outlier from data anomalies, which could reverse with future downside surprises, or presents substantiative and persistent strength.

Fed funds rate and food/energy CPI
Recessions are shaded, 1965–present

Line graph of fed funds rates and food/energy CPI from 1965-2023

Source: Bureau of Labor Statistics, Federal Reserve, NBER, Bloomberg, Principal Asset Management. Data as of March 3, 2023.

Could a soft landing (although improbable) save earnings?

While an economic recession does tend to deepen an earnings recession, earnings recessions can nonetheless occur in the absence of an economic recession. In instances where any given year experiences a higher U.S. dollar, higher oil prices, and higher interest rates, typically an earnings recession should be expected in the near future. 2022 fit the criteria—oil prices reached their highest level in 14 years, the U.S. dollar index reached 20-year highs, and the Federal Reserve raised interest rates by 4.25% in just nine months, its fastest pace since the early 1980s.

Earnings relationship to the dollar, oil, and treasury yields
1968–present

Line graph showing earnings relationship to the dollar, oil, and treasury yields from 1968-2023

USD, oil, rates represented by: U.S. dollar index, West Texas Intermediate crude oil, and 10y US Treasury yield. 
Source: Federal Reserve, Yale University, Robert J. Shiller, U.S. Energy Information Administration, CME, Bloomberg, Principal Asset Allocation. Data as of March 6, 2023.

Even if the Fed manages to engineer a soft landing, an earnings recession may already be in the cards. Reported S&P 500 earnings have already been slowing since their peak in mid-2022, and these have been bolstered by surging profitability in the energy sector. In fact, 4Q22 earnings are expected to have contracted -3.2%, but without the energy sector’s support, this falls to a -7.4% contraction.

Earnings do typically get revised downward as a new calendar year evolves, and in 2023, earnings are now expected to shrink modestly over the next 12 months. So, beginning this year with weakening growth expectations (which have now slipped into a modest contraction) would imply more than just a possibility of a deeper earnings contraction ahead.

The likely earnings recession’s impact on markets

Today, the stocks of the S&P 500 are valued at about 17.9x forward earnings, above the 15-year median of 16.1x, suggesting that positive earnings growth expectations remain embedded in price levels. In fact, equity valuations currently do not appear to be pricing an earnings recession, never mind a broader economic recession. Once earnings begin to disappoint, and future earnings expectations are revised downward, this could then present a significant risk to equity levels.

Despite some recent monthly improvements in economic survey data, as well as upside surprises and resilience in harder economic data, leading indicators still suggest that more economic slowing is ahead, and are consistent with lower inflation, lower earnings, lower GDP growth, and lower multiples. These indicators imply that while the U.S. will enter recession sometime in late 2023, it will likely not be confirmed by the National Bureau of Economic Research (NBER) dating committee until 2024.

Consequently, investors would be well suited to remain cautious about equities, especially richly valued markets and domestically cyclical sectors. Remaining defensive, with exposure to more acyclical equities like healthcare, utilities, and consumer staples, should help weather the growing profit and recession risks that are steadily emerging.

Disclosure

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