Global equity markets are fixated on the Federal Reserve “pivot.” Investors appear glued to every detail of every speech delivered by Fed Chair Jay Powell and members of his policy committee, the Federal Open Market Committee. Interest rates are important, they affect economic activity and they set the discount rate used to price company earnings, but where would we be without earnings. Earnings are even more important than interest rates and monetary policy. They ultimately drive dividends and share prices. Markets go through cycles of falling and rising interest rates but over time they keep rising in line with earnings growth.

The third quarter (Q3) earnings season has kicked off in the US. There have been some high-profile earnings misses and profit warnings, including Advanced Micro Devices, FedEx Corp, Nike, and CarMax. In 2020 and 2021, there was a global shortage of semiconductors, logistics capacity, trainers, and vehicles, amid a fiscally driven surge in demand. Demand is now easing rapidly as inflation cuts into household disposable income and companies are battling to pass higher costs onto their customers. Revenues are slowing and profit margins are shrinking.

Analysts have been steadily cutting earnings forecasts. At the start of the quarter, the consensus Q3 forecast for the S&P 500 index was year-on-year revenue growth of 9.7% and earnings growth of 9.8%. The revenue growth forecast has slipped to 8.7% while earnings growth has reduced sharply to 2.9%, indicating substantial margin pressure. According to FactSet, this represents the largest cut to earnings estimates within a reporting period since Q2 2020, at the peak of the Covid outbreak. Excluding energy, Q3 earnings would be even worse, predicted to decline by 3.8%.

Companies are facing slowing demand and rising costs, as well as difficult year-on-year comparisons. The deteriorating outlook is being compared with extremely buoyant conditions a year ago. The surging dollar is also reducing the value of overseas earnings. The dollar index has gained by 20% since the start of the year and 40% of S&P 500 revenues come from outside the US. A strengthening dollar lowers the value of foreign revenues and reduces global competitiveness.

The technology sector, which comprises around 40% of US equity markets, has the greatest proportion of foreign earnings. Materials and consumer staples are not far behind, while sectors with the greatest domestic exposure are the banks, financials, utilities, and real estate. Retailers tend to import a lot and so a strong dollar should help them mitigate other cost pressures. Profits recessions favour the more defensive sectors, such as consumer staples, utilities, and healthcare, which people cannot do without.

The S&P 500 index has declined by over 24% since the start of the year. Price-earnings valuations have returned to their long-term average. The estimated 12-month forward price-earnings multiple has dropped from 21x at the start of the year to 15.9x. This is below the 5-year average of 18.6x and the 10-year average of 17.1x. It lies close to the 20-year average of 15.7x. The big question: How accurate is the current 12-month forward PE multiple? After all, it is based on earnings estimates and we have seen how quickly the Q3 estimate has unwound. There is a strong likelihood that earnings forecasts will decline further. Interest rate hikes have an impact delay of 6-12 months and so their effect on earnings may only be felt in 2023.

We should not be surprised if there is an earnings recession. The Fed has stated its commitment to bringing down inflation and that it is willing to incur some pain in the process. JP Morgan CEO Jamie Dimon said on 10th October that the US and global economy could dip into recession by the middle of next year. Earnings will likely contract but the good news, in the US at least, is that a recession will be short and shallow. Banks, companies, and households spent the decade after the 2008/09 Global Financial Crisis mending their over-leveraged balance sheets. The deleveraging process combined with massive excess savings accumulated during the Covid pandemic has removed any structural imbalances. The economy is well equipped to deal with a cyclical downturn.

Bear markets typically suffer two down-legs. The first commonly arises after an economy overheats and monetary conditions need to be tightened. Interest rates rise causing a compression in equity market price-earnings multiples, resulting in a 15-20% market decline. At this stage economic growth can remain buoyant as it takes time for higher interest rates to take effect. A continuation of buoyant conditions often leads to a powerful relief rally, like the one that occurred between the mid-June and mid-August this year. A 15-20% market decline is often followed by a swift 10-15% recovery. The second leg lower takes place if earnings decline and depending on the severity of the recession can lead the market lower by another 15-20%. A new bull market will invariably be born while earnings are still dropping. The price earnings multiple will increase as the market looks through the recession to the recovery ahead, usually due to monetary and fiscal stimulus, and regulatory reforms.

Jamie Dimon said the S&P 500 could fall by “another easy 20%” from current levels, as earnings decline. This would result in exceptional investment opportunities. OAM’s portfolios are defensively positioned with substantial dollar cash holdings accumulated over the past 15 months as the bear market has unfolded. Portfolios can withstand the earnings recession and will exploit the investment opportunities that emerge.