Morgan Stanley
  • Wealth Management
  • Jun 14, 2022

How Can Investors Prepare for a ‘Profits Recession’?

Corporate profits may not be as resilient as investors would like to think. Why weaker earnings—and more volatility—may be ahead.

With markets continuing to descend into bear territory—even giving back all of early June’s gains—some bullish investors remain optimistic about corporate-earnings resilience. We think that’s a mistake.

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Analysts expect company profits to grow about 13.5% this year. That seems high to us and implies that current record-high operating margins are sustainable. The logic behind this? The notion that inflation and interest rates have likely peaked, and with that will come support for stock valuations.

However, we are skeptical about any expected earnings durability and foresee a “profits recession,” or negative year-over-year change in profit growth. Here are three reasons:

  • Many businesses likely “over-earned” last year, amid the rapid V-shaped recovery from the 2020 recession, especially those catering to the stay-at-home trend. It may now be time to give back some of those gains. This means a deceleration in revenue growth, which will likely remain challenging given continued high and broad-based cost pressures from materials, energy and higher wages. The strength of the U.S. dollar is another headwind to margins and international competitiveness.
  • Business leaders have a dim view of the future. A recent survey by the Conference Board saw CEO confidence collapse to a level that historically has coincided with profits recession. Importantly, the National Federation of Independent Business survey of small-business executives echoes this sentiment; its latest reading is the worst in the survey’s history.
  • Markets don’t yet fully reflect tightening financial conditions. Yes, investors have come to discount anticipated rate increases—but higher rates and lower valuations aren’t the full picture. The Fed is still accelerating its rate hikes, and it has only just begun to shrink its balance sheet. The next phase of market adjustment will likely be a reckoning with the impact of higher rates and lower liquidity on the economy and company earnings.

Putting all this together, we think we may be in for a return to prior stock-market lows, as second- and third-quarter earnings results could reveal cyclical vulnerabilities of navigating the other side of last year’s “V.”

Investors should watch for a recalibration of profit expectations. Consider gearing portfolios to both defensive and offensive positions, adding investment grade credit for the former and utilizing a “growth at a reasonable price” stock-picking approach for the latter. And importantly, pursue maximum diversification, including by region, sector and market capitalization.

This article is based on Lisa Shalett’s Global Investment Committee Weekly report from June 13, 2022, “On the Lookout for a Profits Recession.” Ask your Morgan Stanley Financial Advisor for a copy. Listen to the audiocast based on this report.

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