US earnings historically decline by 10% on average during a mild recession

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Before lowering firms’ profits, equity analysts are awaiting confirmation of the economic forecast as well as management’s direction.

US Fed rate hikes are expected to send the economy, officially, into a recession in 2023. In such an environment, corporate earnings fall as a result of falling consumer demand and high borrowing costs. The decline in profit projections across sectors in 2022 is reflected in the stock market decline. Most businesses’ values have decreased, but the changing dynamics in 2023 could paint a different picture for US equities; the battle between earnings and prices will cause market volatility.

“As recession risk looms in the US, the trajectory for the S&P 500 in 2023 will be a case of earnings contraction and valuation expansion,” is what Dylan Cheang, Strategist, DBS Bank says in the DBS 1Q23 CIO Investment Outlook entitled ‘The Return of 60/40’. Here are more excerpts from the report.

In 4Q22 (as of 22 November), the street had revised its forecast for US earnings by 1.2%, and the sectors which saw the largest downward revisions include Financials (-6.2%), Materials (-6.4%), and Consumer Discretionary (-4.3%).

Despite the downgrades, there remains too much optimism prevailing in the market today. On a full-year basis, the street is expecting earnings growth of 7% for 2023 even though recession risks are on the rise.

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As our analysis shows, in the event of a “mild” recession, US earnings historically decline by 10% on average.

We believe the apparent disconnect between analysts’ forecasts and the economic reality on the ground can be attributed to two factors:

  1. While the Fed has embarked on aggressive monetary tightening, the impact has yet to be fully transmitted to the broader economy, and hence, there is still an element of “cautious optimism” in the market.
  2. Equity analysts are waiting for further confirmation on the economic outlook as well as guidance from companies’ management before downgrading their earnings. The 4Q22 reporting season will unveil greater details of how Fed monetary tightening has weighed on corporate earnings.

We expect more earnings downgrades to take place in the early part of 2023 as analysts start to factor in the eventuality of top-line weakness (as a result of a “mild” recession) and margin contraction (as a result of lingering inflationary pressure) over the year.

Also Read: Fed minutes reveal no rate cuts in 2023, economy headed for recession

As further clarity on the US economic outlook emerges in the coming months, downward earnings revisions are expected to gain momentum. On balance, the trajectory for the S&P 500 will be subjected to the cross-currents of earnings contraction and valuation expansion in 2023.

Below are our key assumptions:

• Dovish pivot from the Fed as the US economy moderates. Lower bond yields and by extension, a lower risk-free rate, will lead to valuation expansion.

• We assume mean reversion of the forward P/E to its 5-year average, and this translates to an average valuation expansion of 8% in the US (broadly similar to the average valuation expansion of 7% seen during periods of “mild” recession).

• Sectoral earnings growth currently averages 8%, a level which is overly optimistic in our view. Now, assuming earnings decline by the historical average of 10% instead due to recession, the pullback in earnings will be broadly offset by valuation expansion.