(Bloomberg) – The common wisdom in stock bulls is that if the Federal Reserve wins its battle against inflation, prices will take flight. But the end of rising consumer costs could trigger another round of bad news.
A small chorus of researchers has been warning for months of a potential earnings threat if the campaign to curb inflation succeeds. In particular, the pressure on margins that could arise should an indicator known as corporate operating leverage suffer in an environment where sales flatten out.
The ratio is a measure of the difference between a company’s fixed and variable costs. It can turn negative during peak inflation, when some of a firm’s costs remain high but cannot offset them through price increases because demand has stalled.
While earnings have held up surprisingly well during the pandemic, sparking a series of bear market rallies, a Morgan Stanley team of strategists led by Mike Wilson says a fall in operating leverage could prove to be the final threat to stocks’ ultimate brings lows.
“Thinking about the areas of inflation that are likely to remain more resilient into next year (housing, wages, certain services) and the areas that are likely to slow (commodities) does not paint a constructive picture for S&P margins, in our view 500,” Wilson, one of Wall Street’s biggest stock bearers, wrote in a recent note to clients.
Operating leverage, which his team measured by subtracting revenue growth from earnings-per-share growth, his team says is unlikely to remain positive in the coming quarters. And while he’s one of the many sell-side analysts to raise concerns about a margin squeeze, consensus estimates are still bullish for next year.
For the first quarter of 2023, equities analysts are expecting a 5.56% increase in earnings versus a 5.48% jump in sales on rising margins. The pattern currently holds for full-year 2023 as well: Earnings are expected to grow faster than sales as operating leverage remains positive.
Jonathan Golub of Credit Suisse AG takes Wilson’s view. While explaining his recent downgrade of the S&P 500 target price, he wrote that “a declining CPI combined with sticky wages should lead to a margin squeeze.”
Wilson’s team has been arguing for months that the ultimate bottom for stocks will not be determined by the Fed but by the earnings growth curve. He sees the S&P 500 bottoming out in a 3,000 to 3,400 point range later in 2022 or early next year.
Read more: Morgan Stanley’s Wilson says stocks can boost earnings
While shares are down more than 22% year-to-date, a number of sell-side analysts say bad earnings news has already been priced in and earnings may indeed surprise and rise. Global 12-month expected earnings have been revised down every month for the most recent quarter. For Jim Paulsen of The Leuthold Group – an ardent equity bull – the fact that profit margins broke historical patterns and held up while inflation has soared means they may not come down after all.
But for Liz Ann Sonders, Charles Schwab’s chief investment strategist, profit margins could take a hit if companies lose their power to raise prices enough to offset high fixed costs.
“Inflation, especially early in the cycle, tends to mean pricing power for companies,” Sonders said. “Demand is strong and spending is strong. This is great news for earnings. Then if you lose the demand side and inflation that pushes prices up, you can get in trouble.”
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