An economic slowdown could be a nightmare for corporate profits in 2023

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Wednesday, November 23, 2022

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Revenue, also known as the “top line,” doesn’t have to deteriorate much for earnings to really suffer.

“[A]At the end of the day, it is typically margins that do the heavy lifting on the downside in an earnings downturn, not top line growth, due to the power of negative operating leverage,” wrote Mike Wilson, chief equity strategist at USA at Morgan Stanley, on Monday.

Sales can hold up during a recession, but a deterioration in margins ultimately reduces the earnings outlook.  (Source: Morgan Stanley)

Sales can hold up during a recession, but a deterioration in margins ultimately reduces the earnings outlook. (Source: Morgan Stanley)

Operating leverage is the degree to which the change in revenue translates into operating profit. For example, a company with 5% sales growth and 15% profit growth has higher operating leverage than a company with 5% sales growth and 10% profit growth. And it works both ways: A company with high operating leverage will see profits fall faster as sales decline.

Businesses with a lot of fixed costs relative to variable costs tend to experience high operating leverage.

Wilson offered a bit more color on his current view on operating leverage in a Nov. 7 research note (emphasis added):

…our economists aren’t officially forecasting a recession for the coming year, but they assume we’re just skirting one. As we’ve noted, from a profit standpoint, that may be worse because it means companies are not cutting headcount as they often do when revenue growth slows. That will put even more pressure on margins as the rate of change in real growth and inflation, that is, nominal GDP, falls sharply. In other words, the decline in the rate of change in revenue growth exceeds the ability of companies to adjust quickly enough to avoid negative operating leverage. that’s pushing our EPS forecasts well below consensus for next year. The labor shortage created by lockdowns and deglobalization is reducing the willingness of companies to lay off employees for fear of never getting them back.. This is a new dynamic that US stock investors haven’t had to contemplate in the last 30 years when labor was much more fungible and cheaper.

work represents a massive cost for companies. So when demand cools, it would make sense for companies to lay off employees to cut costs as the amount of work that needs to be done dwindles.

Anthony Harris stops traffic while working with EZ Bel Construction along Fredericksburg Road during an excessive heat warning in San Antonio, Texas, U.S. July 19, 2022. REUTERS/Lisa Krantz

Anthony Harris stops traffic while working with EZ Bel Construction along Fredericksburg Road during an excessive heat warning in San Antonio, Texas, U.S. July 19, 2022. REUTERS/Lisa Krantz

However, the last two years have come with persistent labor shortage as companies had trouble recruiting amid rapid economic recovery. Because they did not have the capacity to meet the demand, the companies lost sales opportunities.

This dynamic has led some economists to speculate that companies would be incentivized to participate in “labor hoarding” or hold on to workers despite slowing demand. The idea is to make sure you have the right staff for when demand finally picks up.

The downside is that labor costs don’t come down as sales deteriorate, putting inordinate pressure on short-term earnings.

This is the negative operating leverage that Wilson is talking about.

And that’s why he expects S&P 500 earnings per share (EPS) to fall to $195 in 2023 from around $219 this year. According to FactSetthe Wall Street consensus estimate is for earnings to rise to $232.

The good news is that Wilson sees this deterioration in profitability as a short-term problem.

“While we see 2023 as a very challenging year for earnings growth, 2024 should be the opposite: a year of rebound growth where positive operating leverage resumes, i.e. the next boom,” he wrote.

With that boom, he estimates that earnings per share will rise to $241 by 2024.

Editor’s Note: The Morning Brief will not be published on Thursday 24 November. We will return to our normal posting hours on Friday, November 25.

what to see today

Economy

  • 7:00 a.m. Eastern Time: MBA Mortgage Applicationsweek ending November 18 (2.7% over the prior week)

  • 8:30 a.m. Eastern Time: Durable Goods OrdersOctober Preview (0.4% expected, 0.4% over prior month)

  • 8:30 a.m. Eastern Time: Durable goods, excluding transportationOctober Preview (0.0% expected, -0.5% over prior month)

  • 8:30 a.m. Eastern Time: unemployment claimsweek ending November 19 (225,000 expected, 222,000 during the week before)

  • 8:30 a.m. Eastern Time: continuing claimsweek ending November 12 (1.520 million during the previous week)

  • 9:45 a.m. Eastern Time: S&P Global US Manufacturing PMINovember preview (50.0 expected, 50.4 during prior month)

  • 9:45 a.m. Eastern Time: S&P Global US Services PMINovember preview (48.0 expected, 47.8 during prior month)

  • 10:00 a.m. Eastern Time: Consumer Sentiment from the University of Michiganend of November (55.0 expected, 54.7 prior)

  • 10:00 a.m. Eastern Time: new home salesOctober (570,000 expected, 603,000 during the previous month)

  • 10:00 a.m. Eastern Time: new home salesmonth-over-month, October (-5.5% expected, -10.9% over prior month)

  • 2:00 p.m. Eastern Time: FOMC meeting minutes, November 1-2

Profits

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