February 9, 2023

Looking Ahead to 2023: End and Beginning of an Earnings Cycle

MFS Investment Management is the sub-advisor to the Sun Life MFS mutual funds

In a recently published article ‘Looking Ahead to 2023: End and Beginning of an Earnings Cycle’ that was first published in the United States by MFS Investment Management, Robert M. Almeida Jr., Portfolio Manager and Global Investment Strategist, discusses his outlook on inflation, recession risks and earnings expectations for the rest of 2023. Here’s a summary of our takeaways.?

Robert M. Almeida, Jr., Portfolio Manager and Global Investment Strategist, MFS Investment Management

Peak inflation? Probably

In recent weeks, after markets were presented with data that pointed to a potential inflation peak, risk assets rallied, led by longer duration stocks and bonds. While only time will tell if inflation has peaked or not, the combination of base effects, the historic pace of tightening financial conditions, and rising recession odds will likely decelerate inflationary pressures in 2023.

While falling inflation may prove beneficial for bonds, it could still prove problematic for profits and consequently stock prices.

Fading wealth effect, rising costs

As economies re-opened in 2021 and consumers were brimming with spending power due to government transfer payments, economic growth and corporate revenues skyrocketed, achieving double-digit growth rates.

Corporate revenues were driven not only by larger volumes of products sold, but also because consumers paid higher prices for goods and services in an inflationary environment.

The pricing power that corporations enjoyed came on the back of a positive wealth effect as consumers felt flush with rising values of homes, stocks, and cars. But pricing power during inflationary booms tend to be ephemeral. For pricing power to be sustained, it must be accompanied by value-add. And that hasn’t occurred over the past year.

As the wealth effect fades due to falling financial asset prices, consumers tend to tighten their budgets. This not only brings down inflation but also the pricing power and profits for corporations.

In short, investors are underappreciating the drag on profits from falling prices.

Will history repeat?

Profits are a function of revenues and costs. While revenues are likely to decelerate with the economy and inflation, costs typically don’t recede as quickly and the earnings cycle ends. History is likely to repeat, and here’s why:

While some companies have announced job cuts, labor market seems tight overall. This should result in sustained elevated labor costs for companies.

The second cost input is capital. While inflation may recede a bit, its not likely to fall to pre-covid levels due to structural dynamics such as an aging population and the corporate sector’s voracious appetite for capital to decarbonize.

While inflation and revenues are likely to recede in 2023, they will do so at speeds much faster than input costs. The result will be a lower profit margin regime than the all-time highs observed over the past several years and I don’t think this is yet reflected in asset prices.

Unrealistic expectations

Historically, in recessionary periods, profit margins plummet. But this time around analysts’ earnings estimates have not fallen far enough.

Even as companies are increasingly recognizing weakening end-demand, they’re also telling investors that they can reduce costs while sustaining historically high margins.

Some scepticism is due here.

While some companies will be able to sustain higher margins because they sell a good or service that’s highly valued by their customers, a majority may struggle. And those most at risk are companies with high and/or inflexible fixed costs and needing to increase capital expenditures to decarbonize amid a higher interest rate, falling inflation, weakening demand, environment.

What to expect for 2023

Decelerating inflation is good for high-quality fixed income but will likely halt this earnings cycle and bring a long overdue profit margin reset. Companies with uncompetitive products or services facing elevated capital costs and mandatory capital investments will be most at risk.

While well-run companies may face some level of margin rest, their ability to grow market share and expand will lead to even better operating performance over the long-term.

The coming inflation slowdown and margin recession will create a new and positive earnings cycle for enterprises with a demonstrable value proposition and an ability to out-earn their natural cost of capital. And that should excite investors.

MFS Investment Management or MFS refers to MFS Investment Management Canada Limited and MFS Institutional Advisors, Inc. MFS Investment Management Canada Limited is the sub-advisor to the Sun Life MFS Funds; SLGI Asset Management Inc. is the registered portfolio manager. MFS Investment Management Canada Limited and MFS Institutional Advisors, Inc. have entered into a sub-advisory agreement.

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