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Wednesday, November 23, 2022
Revenue — aka the "top line" — doesn’t have to deteriorate by much for earnings to really suffer.
“[A]t the end of the day it's typically margins that do the heavy lifting to the downside in an earnings recession, not top line growth, because of the power of negative operating leverage,” Mike Wilson, chief U.S. equity strategist at Morgan Stanley, wrote on Monday.
Operating leverage is the degree to which the change in revenue translates into operating earnings. For example, a company with 5% sales growth and 15% earnings growth has higher operating leverage than a company with 5% sales growth and 10% earnings growth. And it cuts both ways: A company with high operating leverage will see earnings fall faster as sales decline.
Companies with a lot of fixed costs relative to variable costs tend to experience high operating leverage.
Wilson offered a little more color on his current view on operating leverage in a Nov. 7 research note (emphasis added):
… our economists are not officially forecasting a recession for next year, but they assume we barely skirt one. As we have noted, from an earnings standpoint, that may be worse because it means companies are not reducing headcounts as they typically do when revenue growth slows. That will put even more pressure on margins as the rate of change on real growth and inflation – i.e., nominal GDP – fall sharply. In other words, the decline in the rate of change in revenue growth overwhelms the ability of companies to adjust fast enough to avoid the negative operating leverage that is driving our well-below consensus EPS forecasts for next year. The shortage of labor created by the lockdowns and de-globalization is reducing companies' willingness to let employees go for fear of never getting them back. This is a new dynamic that US equity investors haven't had to contemplate over the past 30 years when labor was much more fungible and cheap.
Labor represents a massive cost for companies. And so when demand cools, it would make sense for companies to lay off employees to lower costs as the amount of work that needs doing shrinks.
However, the past two years have come with persistent labor shortages as companies struggled to hire amid the rapid economic recovery. Because they didn’t have the capacity to keep up with demand, companies missed out on sales opportunities.
This dynamic has led some economists to speculate that companies would be incentivized to engage in “labor hoarding” or hang on to workers despite slowing demand. The idea is to make sure you are well-staffed for when demand eventually recovers.
The downside is labor costs don’t come down as sales deteriorate, putting outsized pressure on earnings in the near term.
This is the negative operating leverage Wilson is talking about.
And it’s why he expects S&P 500 earnings per share (EPS) to tumble to $195 in 2023 from about $219 this year. According to FactSet, the Wall Street consensus estimate is for earnings to rise to $232.
The good news is Wilson sees this deterioration in profitability as a short term problem.
“While we see 2023 as a very challenging year for earnings growth, 2024 should be the opposite — a rebound growth year where positive operating leverage resumes — i.e., the next boom,” he wrote.
With that boom, he estimates EPS to jump to $241 in 2024.
Editor's note: There will be no Morning Brief published on Thursday, November 24. We'll return to our normal publishing schedule on Friday, November 25.
What to Watch Today
7:00 a.m. ET: MBA Mortgage Applications, week ended Nov. 18 (2.7% during prior week)
8:30 a.m. ET: Durable Goods Orders, October preliminary (0.4% expected, 0.4% during prior month)
8:30 a.m. ET: Durables Excluding Transportation, October preliminary (0.0% expected, -0.5% during prior month)
8:30 a.m. ET: Initial Jobless Claims, week ended Nov. 19 (225,000 expected, 222,000 during prior week)
8:30 a.m. ET: Continuing Claims, week ended Nov. 12 (1.520 million during prior week)
9:45 a.m. ET: S&P Global U.S. Manufacturing PMI, November preliminary (50.0 expected, 50.4 during prior month)
9:45 a.m. ET: S&P Global U.S. Services PMI, November preliminary (48.0 expected, 47.8 during prior month)
10:00 a.m. ET: University of Michigan Consumer Sentiment, November final (55.0 expected, 54.7 prior)
10:00 a.m. ET: New Home Sales, October (570,000 expected, 603,000 during prior month)
10:00 a.m. ET: New Home Sales, month-over-month, October (-5.5% expected, -10.9% during prior month)
2:00 p.m. ET: FOMC Meeting Minutes, November 1-2