Should investors reset earnings expectations?

Morgan Stanley Wealth Management


Summary: Corporate profits may not be as resilient as analysts’ forecasts. 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 analysts remain optimistic about corporate-earnings resilience.

Analysts expect company profits to grow about 13.5% this year,1 reflecting the view that inflation and interest rates have likely peaked, and with that will come support for stock valuations.

However, according to Morgan Stanley’s Global Investment Committee (GIC), these profit expectations seem high. Looking ahead, the GIC foresees a “profits recession,” or negative year-over-year change in profit growth. Here are three reasons why:

  • 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 slowing of 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 US dollar is another headwind to corporate profits.
  • 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.2 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.3
  • Markets may not fully reflect tightening financial conditions. 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.

Investor playbook

Putting all this together, the GIC thinks stocks may be in for a return to prior lows, as second- and third-quarter earnings results could reveal the challenges of navigating the other side of last year’s impressive V-shaped recovery.

Consider gearing portfolios to both defensive and offensive positions. For defense, consider investment-grade bonds. For offense, explore a “growth at a reasonable price” stock-picking approach. And importantly, make sure portfolios are diversified across region, sector, and market capitalization.

The source of this Morgan Stanley article, How Can Investors Prepare for a ‘Profits Recession’?, was originally published on June 14, 2022.

  1. Morgan Stanley Wealth Management Global Investment Committee, "On the Lookout for a Profits Recession,” June 13, 2022
  2. The Conference Board, US CEO Confidence, May 18, 2022
  3. NFIB, Small Business Optimism Index, April 2022

Risk Considerations

Yields are subject to change with economic conditions. Yield is only one factor that should be considered when making an investment decision.

Equity securities may fluctuate in response to news on companies, industries, market conditions and general economic environment.

Bonds are subject to interest rate risk. When interest rates rise, bond prices fall; generally the longer a bond's maturity, the more sensitive it is to this risk. Bonds may also be subject to call risk, which is the risk that the issuer will redeem the debt at its option, fully or partially, before the scheduled maturity date. The market value of debt instruments may fluctuate, and proceeds from sales prior to maturity may be more or less than the amount originally invested or the maturity value due to changes in market conditions or changes in the credit quality of the issuer. Bonds are subject to the credit risk of the issuer. This is the risk that the issuer might be unable to make interest and/or principal payments on a timely basis. Bonds are also subject to reinvestment risk, which is the risk that principal and/or interest payments from a given investment may be reinvested at a lower interest rate.

Asset allocation and diversification do not assure a profit or protect against loss in declining financial markets.

Rebalancing does not protect against a loss in declining financial markets.  There may be a potential tax implication with a rebalancing strategy.  Investors should consult with their tax advisor before implementing such a strategy.

Because of their narrow focus, sector investments tend to be more volatile than investments that diversify across many sectors and companies. Technology stocks may be especially volatile.

International investing entails greater risk, as well as greater potential rewards compared to U.S. investing. These risks include political and economic uncertainties of foreign countries as well as the risk of currency fluctuations. These risks are magnified in countries with emerging markets, since these countries may have relatively unstable governments and less established markets and economies.

Investing in foreign emerging markets entails greater risks than those normally associated with domestic markets, such as political, currency, economic and market risks.

Investing in commodities entails significant risks. Commodity prices may be affected by a variety of factors at any time, including but not limited to, (i) changes in supply and demand relationships, (ii) governmental programs and policies, (iii) national and international political and economic events, war and terrorist events, (iv) changes in interest and exchange rates, (v) trading activities in commodities and related contracts, (vi) pestilence, technological change and weather, and (vii) the price volatility of a commodity. In addition, the commodities markets are subject to temporary distortions or other disruptions due to various factors, including lack of liquidity, participation of speculators and government intervention.

Certain securities referred to in this material may not have been registered under the U.S. Securities Act of 1933, as amended, and, if not, may not be offered or sold absent an exemption therefrom.  Recipients are required to comply with any legal or contractual restrictions on their purchase, holding, and sale, exercise of rights or performance of obligations under any securities/instruments transaction.

The returns on a portfolio consisting primarily of environmental, social, and governance-aware investments (ESG) may be lower or higher than a portfolio that is more diversified or where decisions are based solely on investment considerations. Because ESG criteria exclude some investments, investors may not be able to take advantage of the same opportunities or market trends as investors that do not use such criteria. The companies identified and investment examples are for illustrative purposes only and should not be deemed a recommendation to purchase, hold or sell any securities or investment products. They are intended to demonstrate the approaches taken by managers who focus on ESG criteria in their investment strategy. There can be no guarantee that a client's account will be managed as described herein.

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