London (Reuters) – The soaring U.S. dollar may finally force business America to recognise a looming profit slump.
So far this summer, the biggest financial puzzle has been how rising inflation and interest rates have lowered economic expectations but haven’t changed the 18-month outlook for firm earnings growth much.
As Wall Street’s top investment banks scramble to place odds on an impending recession-with many predicting at least two consecutive quarters of U.S. economic contraction and others predicting a 50/50 chance of a global downturn-the ‘bottom up’ perspective from boardrooms has remained oddly upbeat.
And this is why the start of the second-quarter earnings season and the accompanying forward guidance are anticipated with such bated breath – not least for a complete report on the post-Ukraine invasion energy shock and rising interest rates.
To date, “top-down‘ recession forecasts have not been accompanied by a reevaluation of profits.
Even with a decline of around 0.5 percentage points from Q2 to Q3, the S&P500’s profit growth for the entire year of 2023 will still exceed 9 percent.
A remark by Jim Wood Smith of Hawksmoor Investment Management remarked, “Economists and investment market strategists are remarkably unified in their forecasts that a recession is inevitable.”
“The only problem is that no one seems to have informed businesses,” he added. The next two or three weeks will be key in settling this tension.
This may just be a delay as equity analysts hesitate in the face of poor macroeconomic forecasts and wait for their businesses to break the bad news to them directly.
Or it may be more basic than it initially appears.
The latest survey of U.S. small businesses shows that in June, business leaders were less optimistic than they had been since 2013. However, there is still a high demand for workers as business owners continue to grow.
And yet, for larger multinationals with global earnings, something more immediate is raising an alarm – the blinding appreciation of the U.S. dollar relative to other major currencies as Federal Reserve tightening swings into overdrive and other central banks dither.
As Extreme As It Is.
Most market watchers are currently focused on the euro’s return to parity for the first time since 2002. However, the dollar is strong against most other currencies, including the Japanese yen and the British pound, and its broad DXY index is at its best level in 20 years.
Only four calendar years in the previous four decades have seen the dollar index rise by more than 12%, and 2022 has already surpassed that mark.
Dixy’s rolling year-over-year gains of greater than 17 percent are already the largest since 2015. Annual gains of more than 20% have been extremely rare since the mid-1980s, occurring only in 2015 and briefly in 2009 during the banking crisis and the dot-com bubble and bust of 2000.
This week, Morgan Stanley (NYSE: MS) strategists dusted up their “ready reckoners” to demonstrate the earnings impact of a “historically extreme” dollar rise.
They concluded that every percentage point increase in the DXY index year over year reduces S&P500 earnings-per-share growth by half a point, implying an 8.5 point EPS growth headwind over the last year.
This could not have occurred at a worse time, since companies are already battling with margin pressure due to cost inflation, increased/unwanted inventory, and sluggish demand.
The risk is that this exacerbates a reduction in both the company’s guidance and profit projections for the next 12 months, and that the more than 20 percent decrease in stock prices so far this year may not have been sufficient to erase historical overvaluation.
If this causes the ratio of prices to expected earnings to go up again, prices may need to go down again to properly price recession risks and keep multiples at their historical averages.
Even while the 16x forward PE is about 30 percent below last year’s highs, it is still approximately 6 points above the 2008/2009 recession low.
A‘moderate recession,‘ for which Goldman Sachs (NYSE:GS) assigns a 30% risk in the coming year, would cause EPS to decrease by 11% to $200 in 2023, which is almost 20% below the current estimate.
Assuming consensus EPS projections are met by the end of the year, a drop in multiples to 14x should result in a 15 to 20% drop in the S&P 500 over the next six months.
Citi strategists project that the current consensus profit growth predictions of 11 percent for this year and 7 percent for next year will fall to less than 5 percent – but believe it might be worse, since there is a 50-50 probability of a global recession in that time frame.
Even this will be too optimistic if a global recession occurs.
The author is the finance and markets editor at Reuters News. His opinions stated here are his alone.
(Twitter (NYSE: TWTR): @reutersMikeD; editing by Mark Potter)