Why stock investors are ‘nervous’ that an earnings recession is looming

Investors fear the stock market is facing an earnings slump, potentially leading to bigger losses after the S&P 500 index just suffered its worst week since March 2020.

“It’s pretty clear that earnings estimates are likely to come down after rising since the first of the year,” Bob Doll, chief investment officer at Crossmark Global Investments, said in a phone interview. “That’s what worries the market,” he said, with investors wondering how bad “bad” earnings could become in a declining economy as the Federal Reserve aims to rein in soaring oil. inflation.

The Fed has become more aggressive in its battle to rein in inflation after it hit its highest level since 1981 in May, adding to fears that the central bank could cause a recession by destroying demand with interest rate hikes. interest aimed at cooling the economy.

Equity valuations have already fallen this year as stocks were too expensive relative to high inflation and interest rates that are no longer close to zero, according to Doll. He said stocks remained under pressure as the Fed’s leeway to engineer a soft landing for the US economy appeared to be shrinking, with heightened concern over slowing economic growth and the cost of living. always stubbornly high.

“People are worried that the Fed will have to rise so much that it will push the economy into a recession,” said Luke Tilley, chief economist at Wilmington Trust, in a telephone interview. “They’re not trying to induce a recession,” he said, but they would induce one if necessary to prevent long-term inflation expectations from becoming “unanchored” and “spinning out of control. “.

Whatever the odds of a “soft landing” before the June 10 consumer price index report shows higher-than-expected inflation in May, “they are smaller now,” said Doll. That’s because the report prompted the Fed, which is lagging the curve, to become more aggressive in tightening monetary policy, he said.

The Fed announced on June 15 that it was raising its benchmark interest rate by three-quarters of a percentage point – the biggest increase since 1994 – to a target range of 1.5% to 1.75% to combat the unexpected rise in the cost of living.

That’s well below the 8.6% inflation rate seen in the 12 months to May, as measured by the consumer price index, the rise in the cost of living in the month the latter being driven by higher energy and food prices and rising rents.

In recent quarters, U.S. companies have managed to raise prices to address their own cost pressures, such as labor, materials and transportation, Doll said. But at some point, the consumer takes a pass saying, “”I’m not paying this for this thing anymore. “”

U.S. retail sales fell in May for the first time in five months, according to a June 15 U.S. Commerce Department report. It was the same day the Fed announced its rate hike, with Fed Chairman Jerome Powell holding a press conference on the central bank’s policy decision afterwards.

“Markets should prepare for both weaker growth and higher inflation than the Fed is prepared to acknowledge,” Bank of America economists said in a BofA Global Research report dated 16 June. “President Powell has described the economy as still ‘strong.’ That’s certainly true for the labor market, but we’re tracking very weak GDP growth.

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BofA economists said they now expect ‘just a 1.5% rebound’ in gross domestic product in the second quarter, following a 1.4% drop in GDP in the first three months of the year. “The weakness is not broad enough or long enough to call a recession, but it is concerning,” they wrote.

Stocks and CEO confidence are sinking

The US stock market has sunk this year, with the S&P 500 SPX index,
+0.22%
and technology-heavy Nasdaq Composite COMP,
+1.43%
slide into a bear market. The Dow Jones Industrial Average DJIA,
-0.13%
is approaching bear market territory, which it would enter with a close at least 20% below its 2022 high in early January.

The Dow Jones ended Friday battered by its biggest weekly percentage decline since October 2020, according to Dow Jones Market Data. The S&P 500 had its worst week since March 2020, when stocks were reeling during the COVID-19 crisis.

The selling pressure in the market has been “so extraordinarily strong” that the possibility of a sharp reversal is “always present”, if only as “a counter-trend rally”, said James Solloway, strategist in chief market officer at SEI Investments Co., in a telephone interview.

Meanwhile, CEO confidence has waned.

“The Conference Board’s measure of CEO confidence recently suffered one of the largest sequential declines in decades,” Lisa Shalett, chief investment officer of Morgan Stanley’s wealth management business, said in a note. of June 13. It slumped toward 40, “a reading that has historically coincided with earnings recessions or negative year-over-year earnings swings.”

MORGAN STANLEY WEALTH MANAGEMENT REPORT DATED JUNE 13, 2022


The decline in confidence is “at odds” with the current trend of upward analyst earnings estimates, which have risen since January to imply 13.5% year-on-year growth in 2022, Shalett said in Note. Companies seem unlikely to maintain “record operating profit margins” given slowing GDP growth, she said.

A new survey released Friday by the Conference Board found that more than 60% of CEOs globally expect a recession in their region before the end of 2023, with 15% of CEOs saying their region is already in recession.

According to Yardeni Research, the probability of a recession in the United States is “high”, at 45%.

Lily: “The economy is going to collapse,” says Novogratz, a Wall Street veteran. “We are going into a recession very quickly.”

“As industry analysts cut their profit margin estimates for 2022 and 2023, the forward profit margin reached an all-time high last week,” Yardeni Research wrote in a note dated June 16. namely, Communication Services, Consumer Discretionary and Consumer Staples, while the others are still flying high.

Crossmark’s Doll said an economic recession could drag the S&P 500 below 3,600, and the stock market faces high volatility as it lacks visibility until the end of the Fed hike cycle. The likelihood of a recession rose “by a good amount” after the inflation reading for May, he said.

Next week, investors will see new US economic data on home sales and unemployment insurance claims, as well as readings on US manufacturing and services activity.

“The window for a soft landing is indeed shrinking,” Solloway said. “The question is how long it will take for a recession to materialize,” he said, saying he expects “it will take a while,” maybe at least one year to 18 months.

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