While Canadian profits fell short of what was expected, S&P/TSX Composite Index profits rose by 18 per cent, with the energy sector generating almost two-thirds of that growth.Christopher Katsarov/The Globe and Mail
Earnings season has been one of the stock market’s few recent bright spots, providing a steady drumbeat of solid corporate results in the midst of an on-again, off-again investor freak-out.
But how long can the corporate sector keep delivering double-digit profit growth in the face of rampant inflation, central bank tightening and the growing risk of a recession?
Even as GDP forecasts have been downgraded owing to growing economic threats on the horizon, consensus earnings estimates have barely budged. For both Canada and the U.S., analysts are modelling an average annual pace of roughly 10-per-cent growth through the end of next year.
“Expectations are far too high,” said Bryden Teich, a partner and portfolio manager at Avenue Investment Management. “The next shoe to drop for the market is the realization that earnings are going to have to come down across the board.”
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The market selloff so far has been almost entirely driven by a reconsideration of how stocks should be valued.
Forceful rate hikes by central banks suddenly in inflation-fighting mode have changed the calculus around what kind of price-to-earnings multiples investors are willing to pay.
A reckoning for the towering valuations assigned to U.S. tech stocks through the first two years of the pandemic has led the entire stock universe downward so far in 2022.
The bottom line, however, has been mostly unaffected. S&P 500 companies delivered 11-per-cent earnings growth in the first quarter, beating the average forecast by a wide margin, according to Refinitiv data. And while Canadian profits fell short of what was expected, S&P/TSX Composite Index profits rose by 18 per cent, with the energy sector generating almost two-thirds of that growth.
Judging by the lack of revisions to market forecasts, analysts foresee a smooth ride ahead for North American corporations. The obvious risk to that scenario is a recession.
“Analysts typically don’t see recessions coming,” Ed Yardeni, chief investment strategist at Yardeni Research, said in a note. “When these events are obvious to everyone, they scramble to slash their estimates.”
While Mr. Yardeni added that he believes “the economy is likely to dodge the recession bullet,” others are sounding the alarm about a buildup of serious economic pressures.
In an e-mail to executives this past week, Tesla Inc. CEO Elon Musk said he had a “super bad feeling” about the economy, while JPMorgan Chase & Co. CEO Jamie Dimon spoke of an economic “hurricane … coming our way.”
The impact of rising prices on consumer finances combined with the need for central banks to continue to cool off the economy to tame inflation is a one-two punch that could spark the next major downturn.
The retail sector would be among the early casualties. Terrible quarterly results from both Walmart Inc. and Target Corp. a few weeks ago emphasized the erosive effect of excessive inflation, with costs soaring and consumers pulling back from discretionary purchases. The companies’ stock prices have since declined by 15 per cent and 25 per cent, respectively.
The entire corporate space, retailers included, is positioned for an era of booming profits. But that era may be coming to an end.
In 2021, S&P 500 companies realized a collective profit margin of more than 13 per cent. Never before had that figure exceeded 11 per cent. Total earnings grew by more than 40 per cent last year, driven by vast fiscal stimulus and the ability of corporations to pass higher prices on to consumers.
“Last year was effectively an earnings bubble,” Mr. Teich said. “Lots of companies put up numbers that they will never meet again.” Many of those companies now have bloated cost structures that will not serve them well in a recession, should one materialize.
The correction in stock market valuations has already left a mark on investors. There’s a good chance the earnings side of the equation will deliver the next blow, Martin Roberge, a portfolio strategist at Canaccord Genuity, said in a note.
“Around mid-June a slew of earnings downgrades should act as a brick wall for stocks,” he wrote.
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