Corporate earnings: Growth clouds have arrived
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
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
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
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.
Investing involves risk, including possible loss of principal. Past performance is no guarantee of future results. Asset allocation and diversification do not ensure a profit or protect against a loss. Equity investments involve greater risk, including higher volatility, than fixed-income investments. Inflation and other economic cycles and conditions are difficult to predict and there Is no guarantee that any inflation mitigation/protection strategy will be successful.
This material covers general information only and does not take account of any investor’s investment objectives or financial situation and should not be construed as specific investment advice, a recommendation, or be relied on in any way as a guarantee, promise, forecast or prediction of future events regarding an investment or the markets in general. The opinions and predictions expressed are subject to change without prior notice. The information presented has been derived from sources believed to be accurate; however, we do not independently verify or guarantee its accuracy or validity. Any reference to a specific investment or security does not constitute a recommendation to buy, sell, or hold such investment or security, nor an indication that the investment manager or its affiliates has recommended a specific security for any client account. Subject to any contrary provisions of applicable law, the investment manager and its affiliates, and their officers, directors, employees, agents, disclaim any express or implied warranty of reliability or accuracy and any responsibility arising in any way (including by reason of negligence) for errors or omissions in the information or data provided.
This material may contain ‘forward-looking’ information that is not purely historical in nature and may include, among other things, projections and forecasts. There is no guarantee that any forecasts made will come to pass. Reliance upon information in this material is at the sole discretion of the reader.
Principal Global Investors, LLC (PGI) is registered with the U.S. Commodity Futures Trading Commission (CFTC) as a commodity trading advisor (CTA), a commodity pool operator (CPO) and is a member of the National Futures Association (NFA). PGI advises qualified eligible persons (QEPs) under CFTC Regulation 4.7.
This material is not intended for distribution to or use by any person or entity in any jurisdiction or country where such distribution or use would be contrary to local law or regulation.
This document is intent for use in:
- The United States by Principal Global Investors, LLC, which is regulated by the U.S. Securities and Exchange Commission.
- Europe by Principal Global Investors (EU) Limited, Sobo Works, Windmill Lane, Dublin D02 K156, Ireland. Principal Global Investors (EU) Limited is regulated by the Central Bank of Ireland. In Europe, this document is directed exclusively at Professional Clients and Eligible Counterparties and should not be relied upon by Retail Clients (all as defined by the MiFID). The contents of the document have been approved by the relevant entity. Clients that do not directly contract with Principal Global Investors (Europe) Limited (“PGIE”) or Principal Global Investors (EU) Limited (“PGI EU”) will not benefit from the protections offered by the rules and regulations of the Financial Conduct Authority or the Central Bank of Ireland, including those enacted under MiFID II. Further, where clients do contract with PGIE or PGI EU, PGIE or PGI EU may delegate management authority to affiliates that are not authorized and regulated within Europe and in any such case, the client may not benefit from all protections offered by the rules and regulations of the Financial Conduct Authority, or the Central Bank of Ireland.
- United Kingdom by Principal Global Investors (Europe) Limited, Level 1, 1 Wood Street, London, EC2V 7 JB, registered in England, No. 03819986, which is authorized and regulated by the Financial Conduct Authority ("FCA").
- United Arab Emirates by Principal Global Investors LLC, a branch registered in the Dubai International Financial Centre and authorized by the Dubai Financial Services Authority as a representative office and is delivered on an individual basis to the recipient and should not be passed on or otherwise distributed by the recipient to any other person or organization.
- Singapore by Principal Global Investors (Singapore) Limited (ACRA Reg. No. 199603735H), which is regulated by the Monetary Authority of Singapore and is directed exclusively at institutional investors as defined by the Securities and Futures Act 2001. This advertisement or publication has not been reviewed by the Monetary Authority of Singapore.
- Australia by Principal Global Investors (Australia) Limited (ABN 45 102 488 068, AFS License No. 225385), which is regulated by the Australian Securities and Investments Commission. This document is intended for sophisticated institutional investors only.
- This document is marketing material and is issued in Switzerland by Principal Global Investors (Switzerland) GmbH.
- Hong Kong SAR (China) by Principal Asset Management Company (Asia) Limited, which is regulated by the Securities and Futures Commission and is directed exclusively at professional investors as defined by the Securities and Futures Ordinance. Other APAC Countries, this material is issued for institutional investors only (or professional/sophisticated/qualified investors, as such term may apply in local jurisdictions) and is delivered on an individual basis to the recipient and should not be passed on, used by any person or entity in any jurisdiction or country where such distribution or use would be contrary to local law or regulation.
- Nothing in this document is, and shall not be considered as, an offer of financial products or services in Brazil. This presentation has been prepared for informational purposes only and is intended only for the designated recipients hereof. Principal Global Investors is not a Brazilian financial institution and is not licensed to and does not operate as a financial institution in Brazil.
Insurance products and plan administrative services provided through Principal Life Insurance Co. Principal Funds, Inc. is distributed by Principal Funds Distributor, Inc. Securities are offered through Principal Securities, Inc., 800 547-7754, Member SIPC and/or independent broker/dealers. Principal Life, Principal Funds Distributor, Inc., and Principal Securities are members of the Principal Financial Group®, Des Moines, IA50392.
© 2023, Principal Financial Services, Inc. Principal Asset ManagementSM is a trade name of Principal Global Investors, LLC. Principal®, Principal Financial Group®, Principal Asset Management, and Principal and the logomark design are registered trademarks and service marks of Principal Financial Services, Inc., a Principal Financial Group company, in various countries around the world and may be used only with the permission of Principal Financial Services, Inc.