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Wealth Management

Why Corporate Profits Could Fall Further

Jun 14, 2023

A slowing economy, declining consumption and fading corporate pricing power could weigh on company earnings. How can investors prepare?

Author
Lisa Shalett
Lisa Shalett

Key Takeaways

  • Investors expecting a rapid rebound in corporate profits during the second half of 2023 may be disappointed.
  • Companies may face headwinds from a slowing economy, weaker consumption and less ability to raise prices.
  • To help manage risk, investors should consider longer-duration bonds, cyclical stocks and certain non-U.S. equities.

The S&P 500 Index has climbed 20% from its October 2022 low, touching off what many investors regard as a new bull market. Investors’ optimism about an economic “soft landing” and expectations of a rapid rebound in corporate profits have helped drive recent equity gains. Indeed, the consensus view among equity analysts is that S&P 500 company earnings will rally from a year-over-year decline in the second quarter of 2023 to annualized growth of more than 14% by 2024.

 

While we agree that a soft landing may be possible, a V-shaped bounce-back in corporate profits seems highly implausible, given these serious potential headwinds to earnings:

 

  • A slowing economy: Economic indicators such as the Institute for Supply Management (ISM) indices, new orders, lending conditions, CEO confidence and capital spending intentions have all historically correlated with corporate earnings. All of them are now flashing red, indicating a material economic slowdown. Secular growth stocks, whose outsized gains have powered the S&P 500’s rise in recent months, are unlikely to be immune from this economic slowing, especially as earnings for many such companies are tied to growth in advertising, consumer spending and personal incomes. Add to all this the lagging effects of the Federal Reserve’s rate hikes on the economy and financial conditions that have yet to tighten, and it’s clear how profits may be vulnerable.

 

  • Declining consumption: Investors seem to believe companies can preserve their margins through cost cutting, but such cuts would likely come from job reductions, meaning unemployment begins to rise. This would likely coincide with other pressures, such as dwindling consumer savings and the resumption of student loan repayments, at a pace of $5 billion per month in aggregate—a perfect storm for a bust in consumption that further drags on economic activity.

 

  • Fading corporate pricing power: Companies have benefited from an ability to increase sale prices and keep them elevated, even as input costs have begun to fall. However, with inflation continuing to decline, companies may see their pricing power diminish and their margins come under pressure, especially as consumer spending potentially slows. 

 

Today’s high U.S. stock valuations and expectations leave little room for earnings disappointment. For investors, risk management is critical. We suggest investors rebalance their portfolios to strategic asset allocation benchmarks, using tax-loss harvesting to neutralize extreme divergences in the performance of different holdings.

 

U.S. investors who have barbelled their portfolios with short-duration fixed income on one side and long-duration secular growth stocks on the other should consider adding bonds with longer maturities while buying cyclical and non-U.S. stocks, with a focus on Japan and emerging markets. Commodities including gold may be a good portfolio hedge against falling real, or inflation-adjusted, interest rates and a weaker dollar.

 

This article is based on Lisa Shalett’s Global Investment Committee Weekly report from June 12, 2023, “Revisiting Our Skepticism on Earnings Resilience.” Ask your Morgan Stanley Financial Advisor for a copy. Listen to the audiocast based on this report.

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Index Definitions

S&P 500 Index: The Standard & Poor's (S&P) 500 Index tracks the performance of 500 widely held, large-capitalization US stocks.

Risk Considerations

Equity securities may fluctuate in response to news on companies, industries, market conditions and general economic environment.

The value of fixed income securities will fluctuate and, upon a sale, may be worth more or less than their original cost or maturity value. Bonds are subject to interest rate risk, call risk, reinvestment risk, liquidity risk, and credit risk of the issuer.

High yield bonds (bonds rated below investment grade) may have speculative characteristics and present significant risks beyond those of other securities, including greater credit risk, price volatility, and limited liquidity in the secondary market. High yield bonds should comprise only a limited portion of a balanced portfolio.

Companies paying dividends can reduce or cut payouts at any time.

Asset allocation and diversification do not assure a profit or protect against loss in declining financial markets.

Investing in small- to medium-sized companies entails special risks, such as limited product lines, markets and financial resources, and greater volatility than securities of larger, more established companies.

Because of their narrow focus, sector investments tend to be more volatile than investments that diversify across many sectors and companies. Technology stocks may be especially volatile. Risks applicable to companies in the energy and natural resources sectors include commodity pricing risk, supply and demand risk, depletion risk and exploration risk. Health care sector stocks are subject to government regulation, as well as government approval of products and services, which can significantly impact price and availability, and which can also be significantly affected by rapid obsolescence and patent expirations.

The indices are unmanaged. An investor cannot invest directly in an index. They are shown for illustrative purposes only and do not represent the performance of any specific investment.

The indices selected by Morgan Stanley Wealth Management to measure performance are representative of broad asset classes.  Morgan Stanley Wealth Management retains the right to change representative indices at any time.

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Morgan Stanley Wealth Management is the trade name of Morgan Stanley Smith Barney LLC, a registered broker-dealer in the United States. This material has been prepared for informational purposes only and is not an offer to buy or sell or a solicitation of any offer to buy or sell any security or other financial instrument or to participate in any trading strategy.  Past performance is not necessarily a guide to future performance.

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