The Earnings Crunch Is Here: Time to Move Over, Inflation

Investors are focused on inflation, where this week finally brought the news of slower-than-expected price rises. This is good news for stock and bond prices, which have been under pressure recently. However, earnings are becoming more of a threat, and this could offset the benefits of lower interest rates.

Wall Street analysts have been slashing profit forecasts at a pace rarely seen outside recessions. While recession is increasingly the consensus among economists, risky assets such as shares aren’t yet pricing in significant risk to earnings. This disconnect between the economic reality and the stock market could mean trouble for investors in the months ahead.

The 12-month forward prediction for S&P 500 earnings per share has declined by more than 3% since June, with next year's forecast down by 8%. The only other time that there has been a significantly bigger drop outside of a recession was in 2015, when the Fed was moving toward its first interest rate hike in nine years.

As the reality of the situation begins to set in, it is becoming clear that earnings are still forecast to hit a new high next year. Despite the recent pullback, earnings are still expected to grow by more than 4% next year. While this is much less growth than what was forecast earlier in the year, it is still significant. Every past recession has led to double-digit drops in earnings, so this growth is a positive sign.

The risks of recession are high, according to economists. The most interest-rate-sensitive sectors are already showing weakness, led by housing. The U.K. and Europe are on the brink of recession. Even after slight relaxation of the rules, Covid lockdowns are still stunting China’s growth.

The market believes that inflation will fall without the Fed needing to force the economy to contract.

Karen Karniol-Tambour, co-chief investment officer for sustainability at hedge fund Bridgewater Associates, says that in order to avoid a recession, inflation has to come down without any help.

It is possible for such perfect disinflation to occur. If those who took early retirement or had long Covid come back to work, it will reduce pressure on jobs, and thus wages. If productivity improves quickly and workers spend less time off sick, that also helps. But the main thing that reduces inflation is that the economy slows down, pushed down by higher interest rates. Such a slowdown can easily lead to a recession that destroys earnings, which is one reason why it is historically rare for Fed rate cycles to end in a soft landing for the economy.

The U.S. economy is weakening, and this is causing problems for businesses. Wholesale inventories are up almost 50% since the end of 2020, so any slowdown in sales will quickly lead to reduced orders. New manufacturing orders are already shrinking, according to the monthly Institute of Supply Management survey. This will lead to reduced production and layoffs. Inflation may be weaker, but the economy is also weaker.

According to Edward Cole, managing director of discretionary investments at fund manager Man GLG, historical relations suggest that earnings per share (EPS) could fall to $180, which would be 25% off the consensus. Cole believes that there is a material downside risk from a normal cycle to consensus forecasts, which he feels are way too high.

Mr. Cole doesn't think that a bad outcome is inevitable, where something breaks in the financial system. He believes that this is just a standard recession, of the type the U.S. hasn't had since the early 1990s.

Stocks could theoretically gain even if earnings fall. This could happen if the market is initially even more pessimistic than what actually happens, or if valuations rise enough to offset earnings.

Stocks have certainly fallen a long way, but until the summer, the fall was entirely due to a lower valuation, as interest rates and bond yields rose. Only in recent months have earnings been the driver, and thanks to the recent rally, the stock-price fall attributable to reduced earnings expectations is only about 3%. This doesn't suggest that investors are preparing for bad times ahead.

Robert Buckland, chief global equity strategist at Citigroup, says that the S&P is pricing in a drop in earnings of 5% at most for next year. He notes that this would be a very good outcome, as recessions back to the start of the 1970s have always had much bigger drops in earnings.

For investors, high profit margins are an additional risk. As Mr. Buckland points out, U.S. return on equity is right at the top of the historical range, and much higher than before the pandemic. If earnings were to merely return to the long-run average, this would take them down by more than 40%, even if sales stayed strong.

"If you're going to have a recession, I wouldn't start from here," Mr. Buckland said. He added that the current economic conditions are not ideal for a recession.

Valuations could provide an offset to falling earnings. If stocks are very cheap, as in the early 1980s, valuation rises might allow stocks to gain while profits drop.

The S&P is not cheap. It is back to its average price-to-forward-earnings ratio since the end of the financial crisis in 2009, which is cheaper than it was. But it remains more than 16 times expected year-ahead earnings, which is well above the sub-10 lows of the 1980s and still above the 14 times reached amid recession fears at the end of 2018.

Inflationary pressure typically leads to higher interest rates. However, this week saw lower interest rates, which in turn led to higher valuations. However, in most cases, earnings usually fall much more during a recession than rising valuations can offset.

Investors who believe that the Federal Reserve will be able to successfully land the economy in a soft landing should be content with stock prices at current levels. However, Fed Chairman Jerome Powell's recent comment that the path to a soft landing has narrowed may not inspire confidence. Other investors may be concerned that the market is too optimistic about earnings, even if inflation turns out to be not as bad as feared.