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Why Corporate Profits Could Fall Further

Jun 14, 2023

A slowing economy, declining consumption and fading corporate pricing power could weigh on company earnings. How can investors prepare?

Lisa Shalett

Key Takeaways

  • Investors expecting a rapid rebound in corporate profits during the second half of 2023 may be disappointed.
  • Companies may face headwinds from a slowing economy, weaker consumption and less ability to raise prices.
  • To help manage risk, investors should consider longer-duration bonds, cyclical stocks and certain non-U.S. equities.

The S&P 500 Index has climbed 20% from its October 2022 low, touching off what many investors regard as a new bull market. Investors’ optimism about an economic “soft landing” and expectations of a rapid rebound in corporate profits have helped drive recent equity gains. Indeed, the consensus view among equity analysts is that S&P 500 company earnings will rally from a year-over-year decline in the second quarter of 2023 to annualized growth of more than 14% by 2024.


While we agree that a soft landing may be possible, a V-shaped bounce-back in corporate profits seems highly implausible, given these serious potential headwinds to earnings:


  • A slowing economy: Economic indicators such as the Institute for Supply Management (ISM) indices, new orders, lending conditions, CEO confidence and capital spending intentions have all historically correlated with corporate earnings. All of them are now flashing red, indicating a material economic slowdown. Secular growth stocks, whose outsized gains have powered the S&P 500’s rise in recent months, are unlikely to be immune from this economic slowing, especially as earnings for many such companies are tied to growth in advertising, consumer spending and personal incomes. Add to all this the lagging effects of the Federal Reserve’s rate hikes on the economy and financial conditions that have yet to tighten, and it’s clear how profits may be vulnerable.


  • Declining consumption: Investors seem to believe companies can preserve their margins through cost cutting, but such cuts would likely come from job reductions, meaning unemployment begins to rise. This would likely coincide with other pressures, such as dwindling consumer savings and the resumption of student loan repayments, at a pace of $5 billion per month in aggregate—a perfect storm for a bust in consumption that further drags on economic activity.


  • Fading corporate pricing power: Companies have benefited from an ability to increase sale prices and keep them elevated, even as input costs have begun to fall. However, with inflation continuing to decline, companies may see their pricing power diminish and their margins come under pressure, especially as consumer spending potentially slows. 


Today’s high U.S. stock valuations and expectations leave little room for earnings disappointment. For investors, risk management is critical. We suggest investors rebalance their portfolios to strategic asset allocation benchmarks, using tax-loss harvesting to neutralize extreme divergences in the performance of different holdings.


U.S. investors who have barbelled their portfolios with short-duration fixed income on one side and long-duration secular growth stocks on the other should consider adding bonds with longer maturities while buying cyclical and non-U.S. stocks, with a focus on Japan and emerging markets. Commodities including gold may be a good portfolio hedge against falling real, or inflation-adjusted, interest rates and a weaker dollar.


This article is based on Lisa Shalett’s Global Investment Committee Weekly report from June 12, 2023, “Revisiting Our Skepticism on Earnings Resilience.” Ask your Morgan Stanley Financial Advisor for a copy. Listen to the audiocast based on this report.

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