The entire global economy is bracing for a growth shock. The Federal Reserve has made it clear that Americans should expect a housing correction, higher unemployment, and maybe even a recession as it raises interest rates to cool inflation.
Despite this clear warning, Wall Street is still delusionally optimistic about how the stock market will perform in 2023.
Sure, the S&P 500 has fallen 11%, and the Dow has dropped 9% in the last month. But estimates for how much profit S&P 500 companies will earn next year are still wildly out of sync with what’s coming for the economy.
At the beginning of 2022, the Federal Reserve believed that inflation was transitory — that the supply-demand dislocations caused by the COVID-19 pandemic would clear up without much use of force. Then Russia invaded Ukraine, completely upending food and energy markets. Inflation, it turned out, was stickier than the world had imagined. And so the Federal Reserve began to hike interest rates to slow down our blazing hot economy, overrun with demand.
Federal Reserve chairman Jerome Powell last week reiterated his commitment to beating inflation back down to 2% — even if it means raising rates so high it causes a recession. And, I have admitted, ultimately that will mean pain for the labor market — layoffs.
Wall Street’s rosy projections for corporate profits do not square with what Powell promises is coming for the economy. It’s about getting a reality check.
It’s a long way down
2021 was a bumper year for American capitalism, or for American corporations at least. US corporate-profit margins fattened to unprecedented levels since the 1950s. When supply chains snarled because of the pandemic, companies raised prices. As inflation increased input costs, they raised prices more. Americans had stimulus checks to spend, and interest rates were so low debt was easy to access.
Those pitch-perfect conditions are gone now. And that means profits — a crucial part of how a company’s stock is valued — are going to sink.
Despite the economic mess and worsening profit outlook, Wall Street still seems relatively chill about the markets’ prospects. According to Bloomberg, Wall Street analysts expect S&P 500 companies’ earnings per share to hit $229 in 2023 — a steady increase from their initial 2023 estimate of $211 at the start of this year. Yes, despite the Fed jacking up interest rates and threatening to induce a recession, the market pros have gotten more optimistic about profits next year.
Of course, their models assume that the trend lines of record-breaking profits we’ve seen will continue—perhaps not apace, but at least up and to the right. That doesn’t make sense given the pressure the Federal Reserve is applying to the economy, even if its policies just take it from scorching hot to warm.
Justin Simon, a portfolio manager at the hedge fund Jasper Capital, took me through a worrying thought exercise. Pretend it’s the end of 2019 — not a terrible time for the stock market and the US economy. Even if corporate profits sink back down to that healthy level, it’s still a long way down from where the stock market sits right now.
“The risk to the market right now is that earnings per share normalizes to pre-COVID levels,” Simon said, “roughly $160 a share.” If profits were to fall back in line with earnings, that suggests a 30% to 40% downside to where the market sits right now, according to Simon.
No one knows how high Powell will have to hike rates — or for how long — to cool inflation. Whether that results in a short downturn or a recession, we know that whatever is coming won’t be positive for corporate earnings. Since 1960, earnings have dropped during recessions by an average of 31%. And the longer the economic slump — and by extension the profit slump — lasts, the worse it will be for stocks.
Nothing bad has happened…yet
Wall Street is in denial, in part because the economy has been so resilient. Despite historic inflation, the US consumer has continued to chug along, and unemployment is still at record lows. When Powell announced on Wednesday that the Fed had decided to hike rates by 0.75% the market rose a little, then went sideways before diving off a cliff. Equity investors are confused, as the retired Goldman Sachs partner Abby Joseph Cohen put it in an interview with Bloomberg. They don’t know how this will shake out for the rest of this year, let alone next year.
Companies haven’t really helped to clarify this situation for their investors, either. In fact, it seems they’re lagging behind Powell. Over at Freight Waves, my former colleague Rachel Premack pointed out that a lot of huge companies have been caught flat-footed as Americans changed spending habits to reflect a post-pandemic, high-inflation world. Companies like Amazon, Target, and Ford have had to change plans or lower their earnings estimates. Earlier this month, FedEx reported dismal earnings and lowered its guidance for next year based on the slowing global economy. The company’s stock fell 24% after its announcement. Those are just a few companies — the rest of corporate America is still figuring out what these new conditions mean for them. As interest rates rise, for example, companies that depend on cheap debt or lots of liquidity to survive will face a rude awakening.
This is not a world where earnings keep growing, but the Federal Reserve is changing the parameters of the economy so dramatically that Wall Street’s plug-and-chug models are useless in the face of it. Investors’ estimates will eventually plummet as they finally wake up to the “pain” Powell promised — and when that happens, volatility will reign as shit gets real.
All the visuals you’ve seen of a screaming-red stock market and sweaty traders doing the sign of the cross — those are just the beginning. Wall Street has been flying so high it forgot that stocks don’t always go up. And the higher you fly, the farther you fall.
Linette Lopez is a senior correspondent at Insider.