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It's All About Earnings

• Fundamentals, driven by earnings, will be an important driver of equity returns.

• Analysts have begun downgrading earnings forecasts, but recent market movements may be looking past near-term declines.

• In previous inflationary recessions, earnings declines were less severe than more recent downturns.

The S&P 500 officially entered bear market territory in early July. Since mid-July, however, the S&P 500 has recovered a bit as we entered the busy earnings reporting season.

Earnings are an important driver of equity returns. However, for the second quarter earnings season, concerns are growing that US corporate earnings are increasingly at risk. Challenges facing US companies with significant ex-US operations include a stronger dollar, which is up 9% and near a two-decade high vs a basket of peers, a result of both higher US interest rates and geopolitical tensions. Retailers and consumer discretionary companies have struggled under the backdrop of surging inflation. Higher energy costs and rising rates increase the cost structure of companies and lead to lower profit margins and earnings.

Current economic conditions indicate we may be near or already in the midst of a recession. Looking at past recessions and earnings changes, there are some insights regarding equity returns that may be counter intuitive. The table nearby illustrates the contrast of high CPI (consumer price index) where CPI > 10% vs low CPI where CPI < 10% and the impact to earnings during that period.

20220816-chartFor each of the recessionary periods, the decline in real GDP, the change in nominal GDP, and S&P 500 EPS declines are noted. Each recession was unique, but what could be most relevant from a historical perspective are the high inflationary recessions that happened in the 1970s and early 1980s. Those recessions were characterized by negative real growth but significant positive nominal growth. In those instances, the overall drop in S&P earnings finished between 6% and 17%.

In contrast, during the last two recessions (2007-2009, 2020), growth was negative in both real and nominal terms. During these periods, S&P 500 EPS declines were significantly deeper than prior inflationary recessions.

How deep will the earnings recession be this time around? Time will tell, but if history is any guide, earnings may not fall as dramatically as more recent recessions. The rebound in equity prices over the past few weeks could suggest that investors believe corporate profits will be more resilient than initially feared. Whatever comes to pass, earnings will be an important barometer to keep a close eye on.

Important Disclosures & Definitions

Bear Market: a condition where a market experiences prolonged price declines, usually when securities prices fall 20% or more from recent highs amid widespread pessimism and negative investor sentiment.

Consumer Price Index (CPI): a measure of the average change over time in the prices paid by urban consumers for a representative basket of consumer goods and services. One may not invest directly in an index.

Earnings Recession: a temporary period where corporate earnings have year-over-year declines, generally for two or more quarters in a row.

Fed Funds Rate: the target interest rate set by the Federal Open Market Committee (FOMC). This target is the rate at which the fed suggests commercial banks borrow and lend their excess reserves to each other overnight.

Fundamentals: the basic qualitative and quantitative information that contributes to the financial or economic well-being of a company, such as profitability, revenue, assets, liabilities and growth potential.

Inflationary Recession: a period of temporary economic decline during which real GDP falls while nominal GDP rises.

Nominal Growth (or Current Dollar Growth): economic growth not adjusted for the price changes from inflation and deflation.

Real Growth: economic growth adjusted for the price changes from inflation and deflation.

Recession: a period of temporary economic decline during which trade and industrial activity are reduced, generally identified by a fall in real GDP in two successive quarters.

S&P 500 Index: widely regarded as the best single gauge of large-cap US equities. The index includes 500 leading companies and covers approximately 80% of available market capitalization. One may not invest directly in an index.

Performance data quoted represents past performance. Past performance is no guarantee of future results; current performance may be higher or lower than performance quoted.

One may not invest directly in an index.

AAI000195 10/31/2023

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