Demand and earnings
Monier adds: “To date, companies have done a good job of managing costs, and consumer demand has proved resilient in many countries, but margins could be squeezed further in 2023.”
He says analysts who cover companies listed in developed markets have been downgrading their forecasts for earnings this year.
“(Fourth quarter) earnings were distorted by firms running down pandemic-era inventories and consumers spending pandemic-era savings, and neither will last indefinitely.
"Companies could face an ongoing hit to margins in 2023 amid slowing demand and still-high inflation. The outlook is unusually hard to predict.
"Big US retailers say spending on clothing and electronics has dipped in recent months. Meanwhile, there is a limit to how much firms can pass on cost increases."
For example, food giant Kraft-Heinz is not planning further price increases in 2023, after raising them 15 per cent last year. Pressure on wages continues, with unemployment near record lows in the US and Europe.
For Simon Edelsten, manager of the Artemis Global Select fund, the potential issue for investors is that companies may respond to lower earnings by taking actions which cause a broader recession.
He says: “A squeeze in profit margins across an economy generally leads to very low growth or a recession, especially if coupled with higher interest rates.
"This seems a likely prospect for the year ahead. Indeed, there is a reasonable scenario that, if the US does not have a slowdown this year they will need to raise rates after next year’s election and have a tough 2025. Stock markets may start to discount that ahead of time.”
The potential is for companies to react to lower profits by cutting jobs and this leads to a recession in the real economy.
Something's got to give
Konstantinos Venetis, senior economist at TS Lombard, says economies are caught in a “chicken and egg” scenario, as “firms can only afford to preserve profit margins, maintain a healthy hiring rate and withstand high wage bill increases at the same time if demand holds up; but to a good degree sustaining demand hinges on healthy corporate earnings in the first place.
"Eventually something along this chain breaks, catalysing a drop in services inflation.”
That lower inflation can then support a growth in demand, pushing growth upwards, or it can be the consequence of weakening demand, which can push economies into recession.
