It’s become a growing consensus on Wall Street that earnings, which have held up remarkably well this year, are the next shoe to drop in the market. The thinking behind this view is that the first part of the market decline was a reset in valuations from elevated levels, which has largely played out. Now, the next leg of the market decline will come from the effects of a slowing economy trickling down into earnings.
We agree that earnings estimates are likely to soften, consistent with the downward revisions in the economy’s growth rate since the beginning of the year. However, our take is earnings are not likely to drop as sharply as some fear when looking at the average earnings drawdowns of close to 20% around previous recessions. A key component of our differentiated view is the impact of inflation on sales and profits.
Indeed, investors seem to be focused on earnings relative to slower “real” GDP, or inflation-adjusted, economic growth. That makes sense insofar as inflation has not been an issue over the past 20 years.
However, inflation matters when thinking about earnings. Notably, while real GDP has been sharply cut for 2022 and 2023 that is not the case for nominal GDP, which includes inflation. In fact, nominal GDP for 2022 is currently estimated to be 8.8% vs. 8.0% at the beginning of the year, while for 2023, estimates of 5.1% have remained relatively stable, especially given the cut in real GDP estimates from 2.6% to 1.9%.
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