Valuations or earnings: Which is most important for equity returns in 2023?

Last year was rough for the S&P 500 Index, with investors losing almost 18% in 2022 as market valuations de-rated. With Canada’s energy exposure the S&P/TSX fared somewhat better as resource prices rose, but the index still declined over 8%. With investors looking for directional insights, we believe the focus will shift in 2023 towards earnings, which we believe have peaked as economic growth declines and restrictive monetary policy conditions continue.

Key Points

• Earnings expectations have weakened this year; however, we still expect lower EPS growth than consensus expectations.
• Profit margin changes are a key driver of earnings growth. We expect further margin weakness ahead.
• Our weak earnings outlook leads us to be defensively positioned in portfolios, with a preference for cash and fixed income over equities.

What do earnings tell us?

Following the COVID-19 pandemic, earnings of US and Canadian companies improved for several quarters. However, something stands out to us that is concerning: As time has progressed, this improvement started to level off, meaning that the EPS growth rate has been declining.

Forward looking estimates of earnings growth have also dropped for the next 12 months. Weak consensus expectations have preceded historical bear markets, including the global financial crisis (GFC), the “earnings recession” of 2015/2016, and the onset of the COVID-19 pandemic (see Exhibit 2). Our leading EPS indicator, which uses leading economic and financial indicators to forecast EPS growth, suggests a 6% drop in EPS in the US over the next year as both economic and financial indicators remain weak.¹

The impact of profit margins on EPS

Profit margins are the culprit of the declining EPS story. By the spring of 2022, companies were at a cyclical peak in profit margin levels, but they have since declined 20% in Canada and the US.² Historically, profit margins have declined for extended periods of time—20 months on average—before troughing. We are about to hit the 12-month mark (see Exhibit 3). Our weak macro forecast, leading EPS model, and analysis of previous profit margin cycles suggest to us that EPS growth will be lower than current expectations. 

Both demand and costs can drive a company’s profit margin. On the demand side, we think sales growth will continue to slow alongside our forecasts for weaker GDP and inflation over the upcoming year.

For company costs, a major reason why profit margins are declining is because a tight labor market has contributed to strong wage growth. The gap between job openings (nonfarm) and unemployed persons is the highest on record, as job demand remains far above historical levels. Unit labor costs, which track employee compensation relative to business output, have risen to above 6% growth—far above the 2% average over the previous decade.³

The paradox of thrift—we need a growth catalyst

Can companies manage earnings by cutting costs? This introduces the paradox of thrift; while cost- cutting may have an immediate boost to corporate financial health, overall, more consumers will have less money in their pockets due to higher unemployment. Consequently, higher unemployment further weakens demand for goods and services, especially for the companies that provide them.

Central Banks to the Rescue?

Inflation remains well above target for central banks including the BoC and the FED. We believe that reining in inflation is still the primary focus of central banks and will require higher policy rates than what markets currently expect throughout 2023. The continuation of tighter financial conditions will pressure most corporate bottom lines in the form of higher borrowing costs.

Multi-asset implications

It is difficult to be bullish on risky assets given the earnings hurdle discussed above. This is especially true when cash and fixed income instruments are finally providing appealing yields. With yields having reset, we prefer cash and fixed income over equities. We believe bonds have decoupled from stocks, and going forward will once again serve as a defensive play during times of economic hardship and stock market weakness.