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Has the slowing economy hurt corporate earnings?

Earnings growth has moderated but remains positive despite negative GDP prints through the first half of the year.

Earnings tend to move with nominal GDP chartStock prices have fallen this year, as surging interest rates caused a re-rating of stock valuations, reducing the froth in equity markets and bringing valuations back to more normal levels. At the same time, with economic growth slowing considerably and recession risks rising, concerns for earnings — and what that could mean for stock prices — have increased. Although stock valuations are much more reasonable today than they have been in some time, a decline in earnings (the denominator in the price-to-earnings ratio) would be another ominous sign for investors and likely provide the catalyst for additional market volatility.

These fears aren’t unfounded, as corporate profits typically come under pressure as the economy slows, particularly if that slowdown culminates in recession. Though real GDP turned negative in the first half of the year, nominal growth (real growth plus inflation) increased by about 9% over the year ended June 30. As shown in the chart above, equity earnings, which are reported in nominal terms, tend to track fairly well with nominal GDP. Clearly, slowing demand isn’t good news for stocks, but pricing power can support top-line growth and alleviate the downside from demand destruction.

Inflation can create potential challenges for profit margins and corporate earnings if higher input costs can’t be passed along to customers. Higher prices, particularly for staples like food and gasoline, also squeeze discretionary spending for consumers. Higher interest rates create a headwind to all borrowers also dampening economic growth.

Over the long term, solid growth in the context of stable, low inflation provides a much better backdrop for the economy and for equity markets. In the near term though, companies that can pass along rising costs to their customers may be able to sustain positive earnings growth, even in an economy that’s not otherwise hitting on all cylinders.

Past performance does not guarantee future results. All investments include risk and have the potential for loss as well as gain.

Data sources for peer group comparisons, returns, and standard statistical data are provided by the sources referenced and are based on data obtained from recognized statistical services or other sources believed to be reliable. However, some or all of the information has not been verified prior to the analysis, and we do not make any representations as to its accuracy or completeness. Any analysis nonfactual in nature constitutes only current opinions, which are subject to change. Benchmarks or indices are included for information purposes only to reflect the current market environment; no index is a directly tradable investment. There may be instances when consultant opinions regarding any fundamental or quantitative analysis may not agree.

Plante Moran Financial Advisors (PMFA) publishes this update to convey general information about market conditions and not for the purpose of providing investment advice. Investment in any of the companies or sectors mentioned herein may not be appropriate for you. You should consult a representative from PMFA for investment advice regarding your own situation.

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