If we do get a recession in the U.S., we could see more weaknesses in earnings growth coming through but the experience of past profit cycles during the periods of high inflation show that the dip could be relatively shallow.
Global Market Strategist
- While consensus earnings expectations are still high and have room to come down to closer to mid-single digits, we do not expect there to be an earnings recession this year
- If we do get a recession in the U.S., we could see more weaknesses in earnings growth coming through but the experience of past profit cycles during the periods of high inflation show that the dip could be relatively shallow
- Earnings growth has proven to be more resilient in defensive sectors such as healthcare, consumer staples and utilities during recessions while consumer discretionary and financials are adversely impacted
“Are we there yet?” is probably a question that most investors ask themselves daily as we continue to stumble through one of the most volatile years in markets. The rosy picture at the start of the year quickly took a darker turn as developed market central banks, led by the Federal Reserve (Fed), pivoted to a much more hawkish stance to tame inflation that has since soared to 9.1% year-over-year (y/y) in June, a level was not seen since the early 1980s. The Fed has raised interest rates to a range of 2.25%-2.5% so far and we continue to expect that they will continue hiking, bringing the federal funds rate to 3.25%-3.5% by the end of 2022.
From a market perspective, we have seen the U.S. equities derate significantly, the yield curve inverted and the U.S. dollar strengthened by ~12% since the beginning of this year on the back of rapidly rising discount rates and a dent in risk appetite. There are also concerns that the dollar strength comes at a time when demand is just starting to wane and margin pressures build, posing risks to the U.S. corporate earnings. Cracks are also starting to form in economic data, specifically in the housing market where we saw homebuilder confidence miss expectations significantly and existing home sales falling to 2-year lows. Amidst the gloom, we continue to believe that the resilience of the U.S. consumer and still healthy corporate balance sheets will help bolster activity in the face of slowing growth. Nevertheless, we need to acknowledge that recession risks have clearly risen over the next 12 to 24 months.
Some of you might have already picked up on the fact that consensus expectations are still for the U.S. equities to deliver ~11%/9% earnings growth in 2022/2023 respectively, with cumulative year-to-date earnings revisions still in positive territory. On the surface, this seems incongruous against a backdrop of weaker growth and sentiment. Naturally, the follow-up question that comes to mind is—will there be a significant earnings recession this year that would threaten equity total returns that have already been beaten down significantly? The short answer is—we don’t think so.
While history doesn’t repeat itself, it rhymes. If we look closely at the evolution of the y/y earnings growth throughout business cycles covering eight recessions since Dec’ 68 (see Exhibit 1), there are three key points to note.
Exhibit 1: U.S. Earnings Per Share Growth through the Cycle
1) Earnings growth is at best a coincident/lagging indicator—it reflects the weakness that has already occurred. Across the past eight recessions, you can see that negative y/y earnings growth are typically coincident with recessions and trough earnings occur shortly after the end of each recessionary time period.
2) Historically, leading up to a recession, the median y/y earnings growth experience has been a positive contributor to the U.S. equity returns while valuations detract. It is not until during and after the recession has occurred where we start to see y/y earnings growth detract from returns. However, in that scenario, the re-rating of the multiple has typically more than made-up for the losses stemming from profit losses as the cycle turns.
3) A closer look at the composition of the U.S. equity returns in the ’70s and ’80s when inflation was much higher is interesting as it shows a much stronger detraction from the valuation component of returns, which makes sense in the context of hawkish central bank action contributing to a more rapid increase in interest rates. Earnings growth, however, is surprisingly resilient, with companies displaying an ability to pass on higher costs to the end consumers. It could be partially a reflection that companies have the knowledge that consumers expect higher prices when inflation is high, and inflation becomes the cover for companies to raise prices.
A study1 by the New York Fed also found that the relationship between changes in corporate profits and inflation is positive on average, even when inflation is high, though the significant industry differentiation exists. While we can expect sectors like energy, materials and industrials to benefit from higher earnings growth during inflationary regimes, sector like technology which has higher wage cost structures might struggle more. The skeptics in the room will quickly point to the fact that the sector composition of U.S. equities has changed materially over the last 20 years, where combined sector weights of energy, materials and industrials have fallen from 20+% to low teens while technology’s share has risen to 30+%. This should call into question how comparable the earnings resilience then and now is. It is a fair point, but we have also started to see many more hiring freezes and layoff announcements from companies in more labor-intensive industries in a pre-emptive bid to protect their margins.
While consensus earnings expectations are still high and have room to come down to closer to mid-single digits, we do not expect there to be an earnings recession this year given our assessment of overall recession risks and our understanding of how profit cycles work.
Should we stumble into a U.S. recession much faster than expected, that’s where we could see more weaknesses in earnings growth coming through but the experience of past profit cycles during periods of high inflation show that the dip could be relatively shallow.
On a sector-by-sector basis, during recessions, earnings growth has proven to be more resilient in defensive sectors such as healthcare, consumer staples and utilities as demand is relatively inelastic. Consumer discretionary and financials are adversely impacted as the consumption outlook glooms and loan loss reserves build ahead of a downturn in credit.
For investors who have built up a sizable U.S. equity allocation over the past decade can consider an allocation to other geographies like Asia ex-Japan where the economic recovery continues to rebound, where valuations have already derated significantly and where earnings expectations are already very low (-2% for 2022).