What the slowing economy means for equity investors?

What the slowing economy means for equity investors?

Tim Richardson CFA, Investment Specialist

High interest rates and weak real earnings growth are pushing consumer spending down and slowing the economy. This is now impacting the revenues and earnings of many companies, which risks a further leg down in some share prices.

“People stop buying things, and that is how you turn a slowdown into a recession.” – Janet Yellen, US Secretary of the Treasury

What drove share prices down last year?

Share prices are broadly driven by two factors:

  • Expected future profits
  • The interest rate (known as the equity discount rate) at which the rational investor discounts future cash flows to calculate a stock’s fair value

In practice, share markets are way more complicated and are influenced by (often irrational) human behaviour, but let’s leave this to one side for now.

Equity discount rates increased steeply in 2022, bringing big share price falls. These were driven by a sudden jump in investors’ interest rate expectations as central banks acted to bring soaring inflation back under control. The war in Ukraine and rising US-China trade tensions further increased the risk premium shareholders demand to hold shares during more uncertain economic environments.

But aren’t companies still making profits?

Higher equity discount rates brought lower share prices last year, despite limited signs of falling company profits. Company earnings and forecasts have been a bit lower in recent months, but generally by far less than share price weakness might suggest.

This is because higher interest rates have slowed the economy at a more gradual pace than in previous downturns, such as that which followed the global financial crisis. This is because household balance sheets strengthened during Covid lockdowns when incomes (for many) were largely unaffected yet spending (on travel, dining out, etc.) fell steeply.

Company earnings subsequently have held up as households have dipped into their ‘Covid cushion’ to maintain spending in real (i.e. inflation adjusted) terms. Unfortunately, the Covid cushion is finite and the stability this has brought to consumer spending (and company earnings) is now starting to unwind.

Could share prices fall again when the economy slows?

Four factors may bring weaker profits for many (but not all) companies in this weaker economic environment:

  • Real incomes are falling; wage rises are elevated but remain lower than inflation which remains close to historic highs in the US and Europe. Weaker demand for labour as the economy slows and migration resumes will continue to cool real income growth. This impacts company revenues as consumers spend less.
  • Higher mortgage payments further reduce discretionary household spending, impacting revenues across many businesses. This especially affects economies where variable or short-term fixed rate mortgages are popular, such as Australia and the UK.
  • Rising mortgage rates also affect housing affordability, reducing transactions and impacting businesses whose revenues depend upon home moves. These include property developers, real estate agents, furniture distributors and electrical goods suppliers.
  • Higher interest rates also increase business financing costs and thus reduce earnings, especially for highly geared companies and those with variable rate debt. Higher borrowing costs impact the profitability of new projects, which are less likely to be progressed, further slowing earnings growth.

So what does this mean for investors?

We may well be entering a period in which share markets overall deliver modest returns.

However, in such an environment all stocks are not created equal. Investors should consider which business models have lower sensitivity to elevated interest rates and weak consumer spending. Their focus should be on secular growth trends which will drive earnings independently of the business cycle.

We will look at these issues in more detail in our next article.

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