Earnings season has been one of the stock market’s few recent bright spots, providing a steady stream of strong corporate results amid on-and-off investor panic.
But how long can the corporate sector continue to deliver double-digit earnings growth in the face of runaway inflation, central bank tightening and the rising risk of a recession?
Even though GDP forecasts have been lowered due to growing economic threats on the horizon, consensus earnings estimates have barely budged. For both Canada and the US, analysts are modeling an average annual pace of growth of about 10 percent through the end of next year.
“Expectations are too high,” said Bryden Teich, partner and portfolio manager at Avenue Investment Management. “The next shoe to drop for the market is the realization that earnings are going to have to come down across the board.”
The market sell-off so far has been driven almost entirely by a reconsideration of how stocks should be valued.
Sharp rate hikes by central banks suddenly in inflation-fighting mode have changed the calculus on what kind of price-earnings multiples investors are willing to pay.
The reckoning of the high valuations assigned to US technology stocks during the first two years of the pandemic has led the entire stock market universe down so far in 2022.
The final result, however, has not been affected for the most part. S&P 500 companies generated earnings growth of 11 percent in the first quarter, beating the median forecast by a wide margin, according to Refinitiv data. And while Canadian earnings fell short of expectations, S&P/TSX Composite Index earnings rose 18 percent, with the energy sector generating almost two-thirds of that growth.
Judging by the lack of revisions to market forecasts, analysts predict a smooth path for North American companies. The obvious risk for that scenario is a recession.
“Analysts typically don’t see recessions coming,” Ed Yardeni, chief investment strategist at Yardeni Research, said in a note. “When these events are obvious to everyone, they are quick to lower their estimates.”
While Mr. Yardeni added that he thinks the economy “is likely to dodge the bullet of recession,” others are sounding the alarm about a buildup of serious economic pressures.
In an email to executives last week, Tesla Inc. CEO Elon Musk said he had a “very bad feeling” about the economy, while JPMorgan Chase & Co. CEO Jamie Dimon he spoke of an “economic hurricane… that is coming upon us”. ”
The impact of rising prices on consumer finances combined with the need for central banks to continue cooling the economy to control inflation is a double whammy that could trigger the next big recession.
The retail sector would be among the first victims. Dire quarterly results from Walmart Inc. and Target Corp. a few weeks ago underscored the eroding effect of excessive inflation, with costs skyrocketing and consumers withdrawing from discretionary purchases. Since then, the companies’ share prices have declined by 15% and 25%, respectively.
The entire corporate space, including retail, is poised for an era of booming profits. But that era may be coming to an end.
In 2021, S&P 500 companies earned a collective profit margin of more than 13%. Never before has that figure exceeded 11 percent. Total profits grew more than 40 percent last year, boosted by a big fiscal stimulus and the ability of corporations to pass on higher prices to consumers.
“Last year was effectively an earnings bubble,” Teich said. “Many companies put numbers that they will never find again.” Many of those companies now have inflated cost structures that won’t serve them well in a downturn, should it materialize.
The correction in stock market valuations has already left its mark on investors. There’s a good chance the earnings side of the equation will strike next, Martin Roberge, portfolio strategist at Canaccord Genuity, said in a note.
“Around mid-June, a series of downward earnings revisions should act as a brick wall for stocks,” he wrote.
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