Bracing for a U.S. Earnings Recession  | Morgan Stanley (2024)

Many investors are feeling optimistic about corporate earnings growth for 2023. They think the impact of rising interest rates is in the past and are taking for granted that areas such as consumer cyclicals, tech and communications services are due for a comeback after experiencing earnings recessions last year.

Heading into 2023, our earnings forecast was lower than consensus. But today that spread is even greater as we recently cut our 2023 forecast further while the rest of the Street and buy-side analysts have raised their estimates.

We now expect a more meaningful earnings recession (with S&P 500 earnings per share falling 16% for the year to $185 compared with our earlier forecast of $195) that has yet to be priced into the market. At the same time, we also continue to forecast a sharp rebound in earnings-per-share growth in 2024 (+23%) and 2025 (+10%).

Here’s what we think the market may be overlooking and why we are expecting earnings to decline in the remainder of the year.

Hotter but Shorter Cycles

For the past several years, our overarching view on markets has been shaped by our "hotter but shorter" cycle framework. Basing this thesis in part on a comparison with the post-World War II period, which looks similar to today in many respects, we have argued that this cycle would be more extreme than what we have experienced over the past 50 years.

First and foremost, the excess savings built up during WWII and COVID lockdowns were unleashed into the economy when supply of money was constrained. In each case, both fundamentals and asset prices returned to prior cycle highs at a historically rapid pace.

The surge in inflation and earnings in 2021 eventually led the Federal Reserve to tighten policy at the fastest pace in 40 years. The boom, and Fed reaction, proved surprising to many—and we think that the depth of an earnings decline this year and subsequent rebound may also come as a surprise.

We think the boom/bust period that began in 2020 is currently in the bust part of the earnings cycle—a dynamic that we believe has yet to be priced into the bear market that began 18 months ago and has been largely related to higher interest rates. In other words, we expect margins and earnings to decline rapidly as inflation falls.

Investor Optimism and AI Excitement

Investor assumptions on impacts of Fed policy and areas of accelerated earnings growth amid a broader market downturn are now built into consensus expectations, and we respectfully disagree. We think this consensus view stems mostly from some large companies sounding more optimistic about the second half of this year combined with the newfound excitement around artificial intelligence (AI) and what it means for both growth and productivity.

While individual stocks will undoubtedly deliver accelerating growth from spending on AI this year, we don’t think it will be enough to change the trajectory of the overall cyclical earnings trend in a meaningful way. Instead, it may pressure margins further for companies that decide to invest in AI despite flat or slowing top-line growth in the near term.

Earnings Momentum and Quality

Over the past 70 years, earnings recessions have often reached bottom after average annual declines of 16%, the exact decline we are forecasting for 2023. Our earnings models considered the timing and magnitude of the deceleration in earnings growth we have seen so far during this cycle (from 50% to 0% currently). The historical analysis suggests it is unlikely that the earnings recession will stop and reverse at current levels and gives us additional confidence in our estimates.

Finally, earnings quality, as measured by net income to cash flow, recently reached its weakest level in the past 25 years. We see this as yet another warning sign that earnings growth could deteriorate further as the cycle turns and accounting policies reverse or are reset to more conservative assumptions. Moreover, the overearning during the pandemic and low quality of those earnings are broad based because of expected weakness in cash flow.

Given all of this, why would earnings rebound next year? As we head into 2024, we see the market processing a much healthier earnings backdrop. We also note that our 2024 EPS growth estimate of 23% for the year is in line with the historical precedent for earnings one year after earnings growth bottoms. Investors who agree with our earnings forecasts may decide to simply “look through” the downside this year. However, given that stocks are trading at 19 times 12-month consensus earnings versus 16 to 17 times historically, we think that is a risky strategy.