Earnings recession explained: Everything you need to know
In May, Snap (SNAP) announced that it was likely to miss its revenue and EBITDA targets for the second quarter after disappointing first-quarter results. The US-based operator of instant messaging application Snapchat blamed the deteriorating macroeconomic environment, including rising inflation, for its gloomy earnings outlook.
Snap is not the only company missing its earnings estimates and revising targets. Meta (META), Facebook’s parent company, missed its first-quarter earnings expectations. Google’s parent company Alphabet (GOOGL) reported in April that its earnings were lower than predicted and growth in its YouTube business slowed significantly compared to last year.
In May, retail giants Walmart (WMT) and Target (TGT) reported that their first-quarter earnings fell short of expectations, citing rising costs and persistent supply chain issues.
Are companies entering an earnings recession, and how can investors protect themselves from the downturns? Here we take a look at what is an earnings recession and whether it’s coming in the next earnings season.
Earnings recession explained
Earnings recession is defined as a period when corporate profits are down from a year ago for two consecutive quarters. An earnings recession typically occurs during an economic slowdown or economic recession.
The US National Bureau of Economic Research (NBER) defines a recession as “a significant decline in economic activity spread across the economy, lasting more than a few months, normally visible in real Gross Domestic Product (GDP), real income, employment, industrial production, and wholesale-retail sales.”
A recession begins just after the economy hit a peak of activity and ends as the economy reaches its trough, according to the bureau.
Recession is typically marked with reduced output and surging unemployment as companies or government offices reduce workers to cut costs. Based on NBER data, there have been 10 periods of recession in the US since 1957.
Recessions are often driven by a combination of variables such as high interest rates and poor consumer confidence.
Risks of recession in the US currently stem from the US Federal Reserve’s (Fed) aggressive tightening of monetary policy to tame four-decades high inflation. US inflation accelerated to 8.6% in May, the highest increase since December 1981, the Bureau of Labor Statistics announced on 10 June. The country’s inflation in April stood at 8.3%.
The Fed responded to rising inflation with a 0.75 percentage point rate hike on 15 June – the biggest increase since 1994. While acknowledging the rise was an “unusually large one”, Fed chairman Jerome Powell suggested a further 50 or 75 basis point increase is possible at the Fed’s next meeting in July.
The Fed’s policy of raising interest rates to slow economic growth and lower inflation heightened risks of economic contraction. Corporate earnings depend on economic growth – as the economic activity slows and borrowing costs increase, a company’s earnings may deteriorate, causing an earnings recession.
First-quarter earnings recap
The US benchmark S&P 500 (US500) index recorded an earnings growth rate of 9% in the first quarter of 2022, the lowest percentage since the fourth quarter of 2020, according to Facset’s data.
As many as 68 companies in the index gave negative earnings per share (EPS) guidance, which was the highest number since Q4 2019.
Of the 11 sectors in the index, energy posted the highest earning growth of 268%. Energy companies have benefited from rallying oil and gas prices since the last quarter of 2021 because supply was unable to keep up with the rebounding demand as countries lifted Covid-19 restrictions.
The war between Russia and Ukraine has fuelled the energy prices rally as Western nations imposed sanctions to target Russia’s oil exports. In the first quarter, the international benchmark Brent crude gained more than 38% after briefly crossing $139 a barrel on 7 March.
Inflation was the main concern in the first quarter. The term “inflation” was mentioned at least once during the earnings calls of 398 companies on the index between 15 March to 24 May.
In terms of the EPS growth, the S&P 500 recorded a blended rate of 4.4% for the first quarter year-over-year (YoY), according to S&P Global’s data. Energy had the highest growth at 225.9%, followed by consumer discretionary and materials at 45.2% and 33.4%, respectively. Communication services suffered the lowest negative growth of -5.7% year-on-year.
What to expect from the next earnings season
With the Fed set to continue with rate hikes, what does the next earnings season have in store?
Capital.com’s Cingari said profit margin decreases may be a warning sign for forthcoming corporate earnings seasons, as rising input prices and decreasing revenues harm US companies’ profitability.
Investment research firm Zacks forecast total S&P 500 earnings to rise by 2.1% in the second quarter of 2022 from the same period last year. But without a hefty contribution from the energy sector, index earnings in the second quarter are expected to fall by -5.2%.
For the full calendar year, Zacks estimated total S&P earnings to rise by 8.9% in 2022 and 9.0% in 2023. If earnings from the energy sector are not taken into account, the index’s earnings in 2022 would grow by only 3.6%.
Facset forecast S&P 500 companies to report annual earnings growth rate of 4.3% in the second quarter, lower than the 5.9% estimated on 31 March, according to a note published on 17 June.
The downward forecast revision was due to more companies issuing negative EPS guidance and net downward revisions to earnings estimates. If 4.3% is actual growth, it will be the lowest earnings reported by the index since the fourth quarter of 2020.
For the third and fourth quarters, Facset analysts forecast earnings growth of 10.7% and 10.1%, respectively, while full-year earnings growth was expected at 10.4%.
Capital Economics also suggested the possibility of disappointing S&P 500 earnings growth due to tightening monetary policy.
“Our new forecasts for tighter monetary policy probably mean US economic activity – and therefore corporate earnings growth – will be a bit weaker than we had previously anticipated,” they said in a note on 17 June.
Capital Economics forecast the S&P 500 to fall from 24 June level of 3,700 to 3,400 by the end of this year, and to 3,200 by end-2023. After that, they suggested, the index could recover, reaching 3,600 by end-2024.
Note that analysts’ predictions can be wrong. Forecasts shouldn’t be used as substitutes for your own research. Always conduct your own diligence and remember that your decision to trade or invest should depend on your risk tolerance, expertise in the market, portfolio size and goals.
Keep in mind that past performance doesn’t guarantee future returns. And never invest or trade money you cannot afford to lose.
How to prepare for an earnings recession
David Jones, Capital.com’s chief marketing strategist said an earnings recession does not have to be necessarily bad and should have been already expected by investors, given the slowdown in the global economy amid high inflation and rising interest rates.
“It has been no secret that times have been tougher for many companies. So one thing that investors should watch for is how the stock price reacts to worse than expected earnings,” Jones said.
“If a stock price was to rally on weak earnings, it could be a sign that the market has already factored the bad news into the price. Markets are always looking forward and weaker earnings are going to be no surprise - it could actually provide some interesting opportunities for investors where on some stocks at least, stronger performance after weaker earnings could be the sign that sentiment is finally starting to change.”
Capital.com’s Cingari pointed out that pricing power – a company's ability to increase product or service prices without losing demand - could be a key factor to watch out for when selecting stocks during the current period of earnings recession. Income stocks that pay higher dividend yields could also be an option to consider.
“Historically, companies with pricing power could adjust their prices to keep up with inflation, minimising the impact on their profitability. Companies that consistently pay dividends may see interest during downturn periods,” he said.
In terms of sectors, utilities and healthcare may fit these criteria, while cyclical sectors such as energy and financials may suffer during slowdowns. “Although the former might still enjoy windfall gains if oil prices don’t fall substantially,” he added.
FAQs
What to invest in during a recession?
According to Capital.com’s analyst Piero Cingari, companies with higher pricing power and those that consistently pay dividends, such as utilities and healthcare stocks, may outperform during the downturn. Note that analyst predictions can be wrong. Forecasts shouldn’t be used as a substitute for your own research. Keep in mind that past performance doesn’t guarantee future returns. And never invest or trade money you cannot afford to lose.
How often does recession happen?
According to data from the US National Bureau of Economic Research (NBER), there have been 10 recession periods in the US since 1957. Each recession period lasted for an average of 13 months, according to calculation by Jefferies.
How do recessions affect the economy?
Rising unemployment is one of the key consequences of a recession. It is most common among low-skilled workers, as they are generally the first to go when corporations or government agencies lay off staff to cut expenses. Increased unemployment could force the government to expand government-funded relief programmes to assist families affected by layoffs in making ends meet. Another effect of the recession is that more businesses could collapse and production falls.
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