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

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Wednesday, November 23, 2022

Today’s newsletter is over Sam Rothe author of TKer.co. Follow him on Twitter @SamRo. Read this and more market news along the way Yahoo Finance app.

Turnover — also referred to as the “top line” — doesn’t have to deteriorate much for earnings to really suffer.

“[A]At the end of the day, it’s usually margins that do the heavy lifting in an earnings recession, not revenue growth, because of the power of negative operating leverage,” Mike Wilson, chief U.S. equity strategist at Morgan Stanley, wrote on Monday. .

Turnover can remain stable during a recession, but a deterioration in margins ultimately depresses the profit picture.  (Source: MorganStanley)

Turnover can remain stable during a recession, but a deterioration in margins ultimately depresses the profit picture. (Source: MorganStanley)

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

Companies with high fixed costs relative to variable costs often experience high operational leverage.

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

…our economists do not officially predict a recession for next year, but they assume that we will hardly avoid it. As we noted, from a revenue standpoint that can be worse because it means companies don’t reduce headcount as they usually do when revenue growth slows. This will put further pressure on margins as the rate of change in real growth and inflation – ie nominal GDP – falls sharply. In other words, the slowdown in the rate of change in revenue growth overwhelms companies’ ability to adapt quickly enough to avoid the negative operating leverage that is the driving force behind our earnings forecasts that are well below consensus for next year. The labor shortage created by the lockdowns and de-globalization is reducing companies’ willingness to let workers go for fear of never getting them back. This is a new dynamic that US equity investors have not had to reckon with in the last 30 years, when labor was much more fungible and cheaper.

Labor represents one huge costs for companies. And so as demand cools, it would make sense for companies to lay off employees to reduce costs as the amount of work to be done decreases.

Anthony Harris halts traffic as he works 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 halts traffic as he works 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 past two years have been accompanied by persistent labor shortages as companies struggled to hire amid the rapid economic recovery. Lacking the capacity to keep up with demand, companies missed sales opportunities.

This dynamic has led some economists to speculate that firms would be incentivized to engage in “labour hoarding” or to retain workers despite declining demand. The idea is to make sure you’re well-staffed for when demand eventually recovers.

The flip side is that labor costs do not fall as sales deteriorate, putting a lot of pressure on profits in the short term.

This is the negative operating leverage Wilson is talking about.

And that’s why he expects the S&P 500’s earnings per share (EPS) to fall from about $219 this year to $195 in 2023. According to FactSet, Wall Street’s consensus estimate is that earnings will 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 growth rebound year where positive operating leverage resumes — that is, the next boom,” he wrote.

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

Editor’s Note: No Morning Brief will be published on Thursday, November 24. We will return to our normal publishing schedule on Friday, November 25.

What to watch today

Economy

  • 7 a.m. ET: MBA Mortgage Applicationsweek ending November 18 (2.7% over previous week)

  • 8:30 a.m. ET: durable goods ordersOctober tentative (0.4% expected, 0.4% last month)

  • 8:30 a.m. ET: Durable goods Excluding transportOctober provisional (0.0% expected, -0.5% during previous month)

  • 8:30 a.m. ET: Initial unemployment claimsweek ending November 19 (225,000 expected, 222,000 in previous week)

  • 8:30 a.m. ET: Ongoing Claimsweek ended November 12 (1.520 million in previous week)

  • 9:45 a.m. ET: S&P Global US Manufacturing PMIprovisional November (50.0 expected, 50.4 in previous month)

  • 9:45 a.m. ET: S&P Global US Services PMIprovisional November (48.0 expected, 47.8 in previous month)

  • 10 a.m. ET: Consumer Confidence from the University of MichiganNovember final (55.0 expected, 54.7 earlier)

  • 10 a.m. ET: New home salesOctober (570,000 expected, 603,000 last month)

  • 10 a.m. ET: New home salesmonth-on-month, October (-5.5% expected, -10.9% last month)

  • 2:00 PM ET: FOMC meeting minutes, November 1-2

Revenue

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