An economic slowdown could be a nightmare for corporate earnings in 2023

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Wednesday 23 November 2022

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Revenue, aka the “top line,” doesn’t have to deteriorate much for earnings to really suffer.

“[A]t at the end of the day it’s typically margins that do the heavy lifting to the downside in an earnings downturn, not top-line growth, because of the power of negative operating leverage,” wrote Mike Wilson, chief US equity strategist at Morgan Stanley, on Monday.

Sales might hold up during a recession, but a deterioration in margins ultimately drags the earnings picture down. (Source: Morgan Stanley)

Operating leverage is the degree to which the change in revenue translates into operating profits. For example, a company with 5% sales growth and 15% earnings growth has higher operating leverage than a company with 5% sales growth and 10% earnings growth. And it cuts both ways: A company with high operating leverage will see profits fall faster as sales drop.

Firms with a lot of fixed costs versus variable costs tend to experience high operating leverage.

Wilson offered a little more color on his current view of operating leverage in a Nov. 7 research note (emphasis added):

… our economists don’t officially forecast a recession next year, but they assume we’ll just barely avoid one. As we’ve noted, from an earnings perspective, it could be worse because it means companies aren’t cutting headcount as they typically do when revenue growth slows. This will put even more pressure on margins as the rate of change in real growth and inflation, i.e. nominal GDP, will decline sharply. In other words, the declining rate of change in revenue growth overwhelms companies’ ability to adjust fast enough to avoid negative operating leverage this is driving our EPS forecast well below the consensus for next year. Labor shortages created by lockdowns and deglobalization are reducing companies’ willingness to lay off employees for fear of never having them back. This is a new dynamic that US equity investors have not had to contemplate over the past 30 years, when labor was much more fungible and cheaper.

The work represents a huge cost for companies. And so when demand cools, it would make sense for companies to lay off employees to reduce costs as the amount of work that needs to be cut shrinks.

Anthony Harris disrupts traffic as he works with EZ Bel Construction along Fredericksburg Road during an excessive heat alert in San Antonio, Texas U.S. July 19, 2022. REUTERS/Lisa Krantz

Anthony Harris disrupts traffic as he works with EZ Bel Construction along Fredericksburg Road during an excessive heat alert in San Antonio, Texas U.S. July 19, 2022. REUTERS/Lisa Krantz

However, the last two years have been characterized by a persistent labor shortage as companies have struggled to hire due to the rapid economic recovery. Because they lacked the ability to keep up with demand, companies lost sales opportunities.

This dynamic has led some economists to speculate that firms would have an incentive to engage in “labour hoarding” or retain workers despite slowing demand. The idea is to make sure they are adequately staffed for when demand eventually picks up.

The downside is that labor costs do not fall as sales deteriorate, putting undue pressure on short-term earnings.

This is the negative operating leverage Wilson talks about.

And that’s why it expects S&P 500 earnings per share (EPS) to fall to $195 in 2023 from about $219 this year. According to FactSet, the Wall Street Consensus Estimate calls for earnings to rise to $232.

The good news is that Wilson sees this deteriorating profitability as a short-term problem.

“While we see 2023 as a very challenging year for earnings growth, 2024 should be the opposite: a year of rebounding growth where positive operating leverage resumes, i.e. the next boom,” he wrote.

With that boom, he estimates that EPS will rise to $241 in 2024.

Editor’s note: No Morning Brief will be published on Thursday, November 24. We will return to our regular posting schedule on Friday November 25th.

What to watch today


  • 7:00 Italian time: MBA Mortgage Applicationsweek ending November 18 (2.7% over previous week)

  • 8:30 Italian time: Durable Goods OrdersOctober Preliminary (0.4% Expected, 0.4% Previous Month)

  • 8:30 Italian time: Durable goods excluding transportOctober Preliminary (0.0% Expected, -0.5% Previous Month)

  • 8:30 Italian time: Initial jobless claimsweek ending November 19 (225,000 expected, 222,000 during prior week)

  • 8:30 Italian time: Continuous complaintsweek ending November 12 (1.520 million during the previous week)

  • 9:45 Italian time: S&P Global US Manufacturing PMINovember preliminary (50.0 expected, 50.4 in prior month)

  • 9:45 Italian time: S&P Global US Services PMINovember Preliminary (48.0 Expected, 47.8 Previous Month)

  • 10:00: University of Michigan Consumer SentimentNovember Finale (55.0 Expected, 54.7 Previous)

  • 10:00: New home salesOctober (570,000 expected, 603,000 in previous month)

  • 10:00: New home salesmonth over month, October (-5.5% expected, -10.9% previous month)

  • 2pm ET: FOMC meeting minutes, November 1-2


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