Earnings Recession in 2023 to Transition to Strong Recovery in 2024

Jun 15, 2023

Morgan Stanley Research strategists think U.S. corporate earnings could decline 16% in 2023 but stage a comeback in 2024 and 2025. Here’s what’s behind the forecast.


Thoughts on the Market

Market Outlook Update: July 25, 2023


Welcome to Thoughts on the Market. I'm Mike Wilson, Chief Investment Officer and Chief U.S. Equity Strategist for Morgan Stanley. Along with my colleagues bringing a variety of perspectives, I'll be talking about the latest trends in the financial marketplace. It's Tuesday, July 25th at 10 a.m. in New York. So let's get after it.

As discussed in last week's podcast, this year's equity market has been all about expanding valuations. The primary drivers of this multiple expansion have been falling inflation and cost cutting rather than accelerating top line growth. Last October, we based our tactically bullish call on the view that inflation was peaking, along with back end interest rates and the US dollar. While the 30% move in equity multiples on the back of this theme has gone much further and persisted longer than we anticipated, we don't feel the urge to turn bullish now. Missing the upside this year was unfortunate, however, compounding with another bad call can lead to permanent loss.

While falling inflation supports the expectations for a Fed pivot on monetary policy, it also poses a risk to nominal revenue growth and earnings. To remind listeners of a key component to our earnings thesis, we believe inflation is now falling even faster than the consensus expects, especially the inflation experienced by companies. With price being the main factor keeping sales growth above zero for many companies this year, it would be a material headwind if that pricing were to roll over. This is precisely what we think is starting to happen for many businesses, especially in the goods portion of the economy.

Last year's earnings disappointment in communication services, consumer discretionary and technology were significant, but largely a function of over-investment and elevated cost structures rather than disappointing sales. In fact, our operational efficiency thesis that worked so well last year was adopted by many of these companies in the fourth quarter, and they've been rewarded for it. From here, though, we think sales estimates will likely have to rise for these stocks to continue to power higher, and this will be the key theme to watch when they report. Last week was not a good start in that regard, as several large cap winners disappointed on earnings and these stocks sold off 10%.

The same thing can be said for the rest of the market, too. If we're right about pricing fading amid falling inflation, then sales will likely disappoint from here. We think it's also worth keeping in mind that the economic data is not always reflective of what companies see in their businesses from a pricing standpoint. Recall in 2020 and 21, the companies were extracting far more than CPI-type pricing as demand surged higher from the fiscal stimulus, just as supply was constrained. This was the inflation driven boom we pointed to at the time, a thesis we are now simply using in reverse.

Bottom line, investors may need to focus more on top line growth acceleration to identify the winners from here. This will be harder to find if our thesis on inflation is correct and cost cutting and better than feared earnings results would no longer get it done, at least in the growth sectors. On the other side of the ledger, we have value stocks where expectations are quite low. Last week, financial stocks outperformed on earnings results that were far from impressive, but not as bad as feared. That trade is likely behind us, but with China now offering some additional fiscal stimulus in the near term, energy and materials stocks may be poised for a catch up move using that same philosophy. In short, growth stocks require top line acceleration at this point to continue their run, while value stocks can do better if things just don't deteriorate further.

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Key Takeaways

  • U.S. strategists expect a meaningful earnings recession of -16% for 2023 and a significant recovery in 2024.  

  • Strategists expect falling inflation could hurt margins and that investors are overly optimistic about the positive impact of AI. 

  • Investors should be cautious of looking past 2023 downside and ahead to the potential 2024 rebound given current valuations.  

Many investors are feeling optimistic about corporate earnings growth for 2023. They think the impact of rising interest rates is in the past and are taking for granted that areas such as consumer cyclicals, tech and communications services are due for a comeback after experiencing earnings recessions last year.  


Heading into 2023, our earnings forecast was lower than consensus. But today that spread is even greater as we recently cut our 2023 forecast further while the rest of the Street and buy-side analysts have raised their estimates.  


We now expect a more meaningful earnings recession (with S&P 500 earnings per share falling 16% for the year to $185 compared with our earlier forecast of $195) that has yet to be priced into the market. At the same time, we also continue to forecast a sharp rebound in earnings-per-share growth in 2024 (+23%) and 2025 (+10%). 


Here’s what we think the market may be overlooking and why we are expecting earnings to decline in the remainder of the year.  


Hotter but Shorter Cycles 

For the past several years, our overarching view on markets has been shaped by our "hotter but shorter" cycle framework. Basing this thesis in part on a comparison with the post-World War II period, which looks similar to today in many respects, we have argued that this cycle would be more extreme than what we have experienced over the past 50 years. 


First and foremost, the excess savings built up during WWII and COVID lockdowns were unleashed into the economy when supply of money was constrained. In each case, both fundamentals and asset prices returned to prior cycle highs at a historically rapid pace. 


The surge in inflation and earnings in 2021 eventually led the Federal Reserve to tighten policy at the fastest pace in 40 years. The boom, and Fed reaction, proved surprising to many—and we think that the depth of an earnings decline this year and subsequent rebound may also come as a surprise.  


We think the boom/bust period that began in 2020 is currently in the bust part of the earnings cycle—a dynamic that we believe has yet to be priced into the bear market that began 18 months ago and has been largely related to higher interest rates. In other words, we expect margins and earnings to decline rapidly as inflation falls. 


Investor Optimism and AI Excitement 

Investor assumptions on impacts of Fed policy and areas of accelerated earnings growth amid a broader market downturn are now built into consensus expectations, and we respectfully disagree. We think this consensus view stems mostly from some large companies sounding more optimistic about the second half of this year combined with the newfound excitement around artificial intelligence (AI) and what it means for both growth and productivity.  


While individual stocks will undoubtedly deliver accelerating growth from spending on AI this year, we don’t think it will be enough to change the trajectory of the overall cyclical earnings trend in a meaningful way. Instead, it may pressure margins further for companies that decide to invest in AI despite flat or slowing top-line growth in the near term. 


Earnings Momentum and Quality 

Over the past 70 years, earnings recessions have often reached bottom after average annual declines of 16%, the exact decline we are forecasting for 2023. Our earnings models considered the timing and magnitude of the deceleration in earnings growth we have seen so far during this cycle (from 50% to 0% currently). The historical analysis suggests it is unlikely that the earnings recession will stop and reverse at current levels and gives us additional confidence in our estimates. 


Finally, earnings quality, as measured by net income to cash flow, recently reached its weakest level in the past 25 years. We see this as yet another warning sign that earnings growth could deteriorate further as the cycle turns and accounting policies reverse or are reset to more conservative assumptions. Moreover, the overearning during the pandemic and low quality of those earnings are broad based because of expected weakness in cash flow. 


Given all of this, why would earnings rebound next year?  As we head into 2024, we see the market processing a much healthier earnings backdrop. We also note that our 2024 EPS growth estimate of 23% for the year is in line with the historical precedent for earnings one year after earnings growth bottoms. Investors who agree with our earnings forecasts may decide to simply “look through” the downside this year. However, given that stocks are trading at 19 times 12-month consensus earnings versus 16 to 17 times historically, we think that is a risky strategy.

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