Register For Our Mailing List

Register to receive our free weekly newsletter including editorials.

Home / 489

Beware the hit to earnings in 2023

Volatility in financial markets happens when participants are faced with new information that runs counter to prior assumptions. This year, the mistaken assumption was inflation, which has proved far more problematic than central bankers and investors expected.

The gyrations across equity and fixed income asset classes in 2022 can be almost entirely traced back to inflation, interest rate levels, and expectations for each. This year, whether it was stocks or bonds, the longer the duration an asset had, the worse it performed. This is important to consider as we set return expectations looking ahead to 2023.

Peak inflation? Probably

In recent weeks, after markets were presented with data that pointed to a potential inflation peak, risk assets rallied, led by longer duration stocks and bonds. While only time will tell if we’ve hit the inflation high-water mark or not, the combination of base effects, the tightening pace of financial conditions, and rising recession odds will likely decelerate inflationary pressures in 2023.

However, not unlike how investors underestimated inflation, I believe they may be underestimating its impact on corporate profits. While falling inflation may prove beneficial for bonds, it could still prove problematic for profits and consequently stock prices.

Fading wealth effect, rising costs

As economies re-opened in 2021 and consumers were brimming with spending power due to government transfer payments, economic growth and corporate revenues skyrocketed, achieving double-digit growth rates.

Corporate revenues can be broken down into units and price. The number of units sold and at what price combine to produce revenues. Not only was unit growth strong, but more notable were prices paid, as evidenced by four-decade high inflation. While corporate input costs were rising, they were matched (or exceeded) by higher prices of goods and services sold, protecting profit margins.

During inflation booms, companies generally raise prices on the back of a positive wealth effect. Rising values for financial assets, used cars, homes, etc., combined in this episode with very high savings and rising wages, to generate significant pricing power for corporations. This cycle was typical for a high inflation period. However, what is also typical is what happens when inflation recedes.

Pricing power during inflationary booms, like the one we just experienced, tend to be ephemeral. For pricing power to be sustained, it must be accompanied by value-add. And that hasn’t occurred over the past year.

As the wealth effect fades due to falling financial asset prices and increasing investor anxiety, consumer behavior changes. And we have already seen signs of it. This earnings season, operating results from some US retailers show that consumers have begun trading down and prioritizing necessities, such as food, over non-essentials. Inflation usually peaks when consumers’ capacity to spend cannot meet the price at the checkout counter.

Falling inflation may potentially lead to higher equity multiples because long-term interest rates may have peaked (and that is good for long duration bonds). Though in my view, investors are underappreciating the drag on profits from falling prices.

Will history repeat?

Profits are a function of revenues and costs. While revenues are likely to decelerate with the economy and inflation, costs typically don’t recede as quickly and the earnings cycle ends. We believe history will repeat, and here’s why:

  • While some companies have announced job cuts, most notably in the technology sector where customer demand is softening, there remains an overall labor shortage combined with a skills mismatch between available workers and the high-skilled jobs that remain unfilled. This should result in sustained elevated labor costs.
  • The second cost input is capital. Following the global financial crisis, central banks made sure capital was both abundant and cheap. While inflation may recede some, it's not likely to fall to pre-covid levels due to structural dynamics at play such as an aging population with more consumers and fewer producers and significant increased capital investment by businesses seeking to decarbonize.
  • While inflation and revenues are likely to recede in 2023, they will do so at speeds much faster than input costs. The result will be a lower profit margin regime than the all-time highs observed over the past several years and I don’t think this is yet reflected in asset prices.

Unrealistic expectations

Exhibit 1 shows analysts’ global earnings expectations over the past several decades. Historically, in recessionary periods, profit margins plummet. But as the data show, analysts’ earnings estimates have slipped, but not by much.

The reasons, I suspect, are simple. Analysts tend to follow corporate guidance. And while companies are increasingly recognizing weakening end-demand, they’re also telling investors that they can reduce costs while sustaining historically high margins. But we have our doubts.

However, some companies will be able to sustain higher margins because they sell a good or service that’s highly valued by their customers. But the reality is that the majority will not. And those most at risk are companies with high and/or inflexible fixed costs and needing to increase capital expenditures to decarbonize amid a higher interest rate, falling inflation, weakening demand, environment.

What we expect for 2023

  • While inflation should decelerate but remain elevated relative to the pre-pandemic period, the slowdown should prove a tailwind for select bonds, particularly high-quality sovereigns, municipalities and investment-grade issues. And relative to equities, bonds haven’t been this cheap in over a decade. The chart below illustrates the ratio between the yield offered by the US 10-year Treasury and the 12-month forward earnings yield on the S&P 500.

  • Decelerating inflation is good for fixed income but will likely halt this earnings cycle and bring a long overdue profit margin reset. But not for all.
  • Companies with uncompetitive products or services facing elevated capital costs and mandatory capital investments will be most at risk. Softer, but still relatively higher inflation compared with the post-GFC period will likely preclude financial bailouts and a return to unnaturally low interest rate regimes. These assets will become stranded.
  • Conversely, while investors may find that even well-run companies have some, albeit small, level of margin reset, the opportunity to grow market share and take greater ownerships of profit pools will lead to even better operating performance over the long-term. The coming inflation slowdown and margin recession will create a new and positive earnings cycle for enterprises with a demonstrable value proposition and an ability to out-earn their natural cost of capital. And I am wildly excited about that.

 

Robert M. Almeida is a Global Investment Strategist and Portfolio Manager at MFS Investment Management. This article is for general informational purposes only and should not be considered investment advice or a recommendation to invest in any security or to adopt any investment strategy. Comments, opinions and analysis are rendered as of the date given and may change without notice due to market conditions and other factors. This article is issued in Australia by MFS International Australia Pty Ltd (ABN 68 607 579 537, AFSL 485343), a sponsor of Firstlinks.

For more articles and papers from MFS, please click here.

Unless otherwise indicated, logos and product and service names are trademarks of MFS® and its affiliates and may be registered in certain countries.

 


 

Leave a Comment:

RELATED ARTICLES

The far-flung past as prologue

Five charts show investors should care about US midterm elections

2022 outlook: buy a raincoat but don't put it on yet

banner

Most viewed in recent weeks

Retirement is a risky business for most people

While encouraging people to draw down on their accumulated wealth in retirement might be good public policy, several million retirees disagree because they are purposefully conserving that capital. It’s time for a different approach.

The perfect portfolio for the next decade

This examines the performance of key asset classes and sub-sectors in 2024 and over longer timeframes, and the lessons that can be drawn for constructing an investment portfolio for the next decade.

UniSuper’s boss flags a potential correction ahead

The CIO of Australia’s fourth largest super fund by assets, John Pearce, suggests the odds favour a flat year for markets, with the possibility of a correction of 10% or more. However, he’ll use any dip as a buying opportunity.

The challenges with building a dividend portfolio

Getting regular, growing income from stocks is tougher with the dividend yield on the ASX nearing 25-year lows. Here are some conventional and not-so-conventional ideas for investors wanting to build a dividend portfolio.

How much do you need to retire?

Australians are used to hearing dire warnings that they don't have enough saved for a comfortable retirement. Yet most people need to save a lot less than you might think — as long as they meet an important condition.

Welcome to Firstlinks Edition 594 with weekend update

It’s well documented that many retirees draw down the minimum amount required and die with much of their super balances untouched. This explores the reasons why and some potential solutions to address the issue.

  • 16 January 2025

Latest Updates

Investment strategies

UniSuper’s boss flags a potential correction ahead

The CIO of Australia’s fourth largest super fund by assets, John Pearce, suggests the odds favour a flat year for markets, with the possibility of a correction of 10% or more. However, he’ll use any dip as a buying opportunity.

9 ways to fix Australia's housing crisis

Decades of policy failure have induced a fall in housing affordability. Unless painful changes are made, an underclass will emerge in a society that is supposed to boast the one of the world's highest standards of living.

Shares

Australia: why the chase for even higher dividend yields?

Australia boasts one of the world's highest dividend yielding sharemarkets, providing substantial benefits to investors and retirees. Despite this, individuals often stretch for even more yield, to their detriment.

Shares

MIGA – Make Income Great Again

The Australian sharemarket seems to be rewarding a number of unprofitable companies on the promise of future riches. Yet profits and cashflows still matter, as a recent case study of Domino's Pizza shows.

Shares

Mapping future US market returns

Exceptional returns from the US sharemarket over the past decade have driven by sales growth, margin expansion, rising valuations, and dividends. Predicting future returns requires careful consideration of these factors.

Shares

Read this before you go all in on US equities

US equities rule global markets, but history is littered with examples of markets that seemed invincible — until they weren’t. Diversification will be key for investor portfolios going forwards.

Property

What impact would scrapping stamp duty have on housing?

Increasing house prices pose challenges for housing affordability. This investigates the impact of stamp duty on the property market, and how removing the tax could help address several key issues.

Sponsors

Alliances

© 2025 Morningstar, Inc. All rights reserved.

Disclaimer
The data, research and opinions provided here are for information purposes; are not an offer to buy or sell a security; and are not warranted to be correct, complete or accurate. Morningstar, its affiliates, and third-party content providers are not responsible for any investment decisions, damages or losses resulting from, or related to, the data and analyses or their use. To the extent any content is general advice, it has been prepared for clients of Morningstar Australasia Pty Ltd (ABN: 95 090 665 544, AFSL: 240892), without reference to your financial objectives, situation or needs. For more information refer to our Financial Services Guide. You should consider the advice in light of these matters and if applicable, the relevant Product Disclosure Statement before making any decision to invest. Past performance does not necessarily indicate a financial product’s future performance. To obtain advice tailored to your situation, contact a professional financial adviser. Articles are current as at date of publication.
This website contains information and opinions provided by third parties. Inclusion of this information does not necessarily represent Morningstar’s positions, strategies or opinions and should not be considered an endorsement by Morningstar.