An earnings recession is coming as the Federal Reserve raises interest rates, which in itself accelerates an economic recession. That should be no surprise given earnings are derived from economic activity.
However, despite the economy already showing signs of weakness, inflation running at the highest level in 40 years and the Fed moving aggressively to tighten monetary policy, Wall Street analysts continue to suggest strong profit margins and rising earnings into 2023.
The Fed on Wednesday raised interest rates by 75 basis points, the biggest increase since the mid-1990s, to curb inflation. The central bank indicated it would keep lifting rates, a strategy that will inevitably hurt the economy and the jobs market.
Read: The Federal Reserve can’t even get the direction of the economy right
Over the long term, the economy grows at about 6%. Therefore, earnings growth also runs at roughly 6% on a peak-to-peak basis. But analysts suggest that earnings growth into 2023 will run well above the historical growth rate despite forecasts of much slower economic activity.
To put that into perspective, analysts’ estimates are currently at the most significant deviation above that 6% earnings growth trend.
The only two previous periods with similar deviations are the 2008-2009 financial crisis and the dot-com bubble that burst in 2000.
While Wall Street analysts currently remain exuberant about earnings growth, an economic reversion resulting from tighter monetary policy will lead to an earnings recession.
As noted, with inflation already running at 40-year highs, the risk of an economic recession has risen markedly in 2022. Historically, when inflation rises by more than 5% annually, an economic contraction has followed.
As shown, “high prices cure high prices” by slowing economic demand. However, as the Fed hikes rates to slow economic growth, thereby reducing inflation, they risk pushing the economy into a contraction. Given consumers’ dependence on low rates to support economic growth, the risk of a policy mistake is elevated.
Of course, since earnings are highly correlated to economic growth, earnings don’t survive rate hikes. As the arrows below show, Fed rate increases consistently lead to earnings recessions.
The Fed is in a difficult position. Producer prices, as shown below, have risen substantially faster than consumer prices have. That suggests companies are absorbing input costs that they can’t pass on to consumers. Eventually, the absorption of higher costs impairs profitability and reduces earnings.
When inflation spreads enough to impair profitability, corporations take defensive measures to reduce costs — layoffs, cost cuts, automation. As job losses increase, consumers reduce spending, which pushes the economy toward a recession.
The economy slows even faster if the Fed hikes rates to slow inflation. While few currently expect an earnings recession, there aren’t many tailwinds supporting economic growth. The combination of geopolitical events and Fed policy will make continued growth even more challenging.
The market is sending a signal
Many analysts and economists are hoping the Fed can engineer a “soft landing” for the economy. In such an instance the economy and inflation slow, but there’s no recession. Given that the surge in economic growth and inflation resultedfrom the massive liquidity injections in 2020-2021, the reversion will be just as significant.
Our composite economic indicator closely tracks the economy using more than 100 data points. Not surprisingly, the surge in the composite from the 2020 lows has already reversed along with earnings growth rates. As noted, the economic and earnings correlation should be no surprise.
The market is also confirming the same. Historically, the stock market leads economic recessions by six to nine months. When the National Bureau of Economic Research announces a recession, it is much too late to matter.
Lastly, during the previous four recessions and subsequent bear markets, the typical revision to consensus EPS estimates before the onset of a recession ranged from -6% to -18%, with a median of -10%. Coming out of recession, analysts start to increase estimates markedly.
Notably, while forward price-to-earnings (P/E) ratios have declined, much of that is due to the drop in the “P” and not the “E.” Therefore, if an earnings recession is coming, as the data suggest, then the current “bear market” cycle still has more work to do.
The realignment of market prices and valuations is always a brutal process. While many believed the Fed had eliminated bear markets and economic recessions, the business cycle can only be delayed but never repealed.
We are just starting the negative-revision phase, which makes risk management in portfolios a priority for now. However, the reversal of those earnings trends will be key in identifying the bear market end and the beginning of the next bull market.
Lance Roberts is chief strategist at RIA Advisors, editor of Real Investment Advice and host of “The Real Investment Hour.”