While economic data in much of the world shows improvement, stock markets have started to move in the opposite direction as a result of what many market participants call an 'earnings recession'.
Lothar Mentel, chief investment officer at Tatton, says this could happen this year because companies were able to pass on higher prices as economies emerged from the pandemic and consumers had excess savings.
He says these price increases were majorly responsible for the inflation of 2022.
But Mentel says as the rate of economic growth declined in 2022, and supply chains re-open, companies will be less able to pass on those price increases, which should mean the rate of inflation declines.
He adds that the present low rate of unemployment could mean a technical recession is avoided in the economy, but the inability of companies to pass on higher costs could mean their profits decline sharply, he calls this an “earnings recession”.
Mentel and says the realisation that this is on the way is key to why equity markets have declined this year, even as economic data to emerge from the US and UK has generally been more positive than expected.
This includes the UK avoiding recession in the final quarter of 2022, and posting purchasing managers index (PMI) numbers which indicated expansion in the services and construction sectors of the economy.
Silvia Dall’Angelo, senior economist at Federated Hermes, says the decline in equity market performance is a function of the market realising “there is no free lunch”, and that stronger economic data now may prompt central banks, institutions which don’t need to care that company earnings are declining, to put rates up further."
She explains: “Economic data continued to surprise to the upside across the board this week.
"Most notably, the flash PMI surveys for Europe, the US and Japan signalled economic activity returned to slightly expansionary territory across all regions in February, with the euro zone and the UK outperforming.
"Yet, markets seemed to reckon the reality that there are no free lunches and a “no landing” scenario is hardly sustainable. Indeed, if economic resilience and inflation stickiness persist, central banks will have to tighten more, which is unlikely to end well for the economic cycle."
According to Dall'Angelo, the current pick-up in economic activity data just adds uncertainty about the timing of the next US recession, which might happen later in 2024 rather than in the second half of 2023.
This is still her base case.
Stephane Monier, chief investment officer at Lombard Odier, says the earnings of S&P 500 listed companies in the US declined in the fourth quarter of 2022, and this was the first such decline since the pandemic, while profit margins declined for the sixth quarter in a row.
He says that while earnings in Europe and the UK rose in the fourth quarter, this growth was influenced by energy company profits in Europe, and energy prices have since declined, and banks in the UK, where the pace of interest rate rises has slowed and so the gains made by those companies may not be as profound in 2023.
