The global economy is cooling significantly and a large number of countries are at risk of recession. Equity valuations have fallen sharply in recent months, but do not yet reflect a drop in profits. And that is exactly what is in store.
CEOs also see the future as a lot less rosy. Their confidence has fallen to its lowest point since May 2020, when we were in the middle of the Covid crisis. The chart below shows that CEO confidence is strongly correlated with the year-on-year change in earnings. Not surprising, of course. If anyone should know how the business is doing, it should be the boss.
The current ‹confidence› of CEOs points to a year-on-year decline in earnings growth of 15 per cent. Given the current P/E ratio of 16.3, a 15 per cent drop in earnings means an 18 per cent increase in the P/E ratio to above 19, ceteris paribus. That is not exactly cheap.
Skewed
There are also two factors that flatter the profits of S&P 500 Index companies. The first is inflation, which artificially pushes up nominal profits. But because that same inflation depresses sentiment among both companies and consumers, the sustainability of that earnings growth is limited.
In addition, the earnings growth of the S&P 500 Index as a whole is entirely driven by basic materials and energy. These are benefiting from the mega increase in commodity prices, while the other industries are just hanging on.
Finally, earnings revisions have turned negative. The expected earnings growth is thus revised downwards, which has a boosting effect on the price/earnings ratio.
Conclusion
Slower economic growth, probably leading to a recession, and persistently high inflation have shaken the confidence of CEOs. This points to negative earnings growth that has not yet been sufficiently priced in by equity markets.
Jeroen Blokland is founder of True Insights, a platform that provides independent research to build diversified multi-asset portfolios. Blokland was most recently head of multi-assets at Robeco. His «chart of the week» appears every Monday on Investment Officer Luxembourg.