Has the slowing economy hurt corporate earnings?
Stock 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.
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