GDP recessions vs earnings recessions
We and much of Wall Street have been singing from the same hymnal for some time now: recession is coming and earnings are going to roll over hard. Ever so slowly, analysts are starting to listen. This chart from Strategas shows how bottom-up earnings estimates for the next 12 months have climbed down since the 2021 peak:
But again: slowly. Yearly profits growth of 5.5 per cent is still the 2023 consensus expectation for the S&P 500. Some think this is plausible. Diane Jaffee, a portfolio manager at TCW, made the point to us last month that a little inflation tends to boost earnings, a nominal variable, and is especially helpful to sectors such as consumer staples. If there’s not a recession, she buys 5 ish per cent earnings growth next year.
A look at net profit margin estimates, derived from analyst revenue and profits estimates, inspires doubt, however. Analysts expect them to nudge up from 12 per cent this year to 12.3 per cent in 2023. According to John Butters of FactSet, such a result would make 2023 profit margins the second-widest since 2008 (when FactSet started tracking this), second only to the bull market of 2021.
That beggars belief, even if you are sceptical that a proper recession is coming. One reason is that sales don’t have to fall much to squish margins. Since most firms have some level of fixed costs, a slowdown or mild contraction in topline revenue can become a heavy weight on margins and earnings. In a note out yesterday, Michael Wilson of Morgan Stanley offers this chart showing how smallish swings in sales become big swings in margins:
Even a sales slowdown, as the chart shows, can significantly compress margins. Not to mention the abundance of recent data pointing to other pressures on margins: elevated wage growth raising fixed costs still higher, or discounted sales of excess inventory dragging down revenue. How all this adds up to 5.5 per cent earnings growth next year is something we cannot figure.