Corporate America’s profit machine has been sputtering in the wake of the most aggressive interest-rate hikes in decades by the Federal Reserve as it battles inflation. That’s left companies in the S&P 500 Index in what’s called an “earnings recession,” or at least two successive quarters of profit declines from previous-year levels. But this hasn’t affected the stock market, which has risen this year on expectations that the downturn is approaching a bottom, if it isn’t there already.

1. What’s behind the earnings recession?

The U.S. economy has continued to grow over the past year, but momentum is slowing and rising interest rates are leading to higher corporate borrowing costs, helping to drive the earnings recession. Profits at companies in the S&P 500 Index as a whole contracted in the last quarter of 2022 and the first three months of 2023. As companies began to report second-quarter earnings in July, they were expected to fall again.  

2. How does this earnings recession compare to previous ones?

Equity analysts forecast that this downturn will last four quarters, longer than the earnings recession in the U.S. early in the Covid-19 pandemic in 2020. Back then, big multinational companies faced supply-chain snarls and inflation that narrowed profit margins. In addition, the stronger U.S. dollar, which was propelled by the Fed increasing interest rates, weighed on earning for businesses that derive most of their revenue overseas. The previous earnings recession lasted five quarters and ended in mid-2016.

3. When will the tide begin to turn?

Wall Street analysts project that in the second quarter S&P 500 companies in aggregate will post a 9% drop in profits from a year ago, marking the steepest contraction since 2020. However, the picture may be somewhat distorted by volatile energy companies facing a decline in fossil-fuel prices. When the energy sector is excluded, earnings growth is expected to resume starting in the third quarter of 2023, according to data compiled by Bloomberg Intelligence. As companies started filing their latest reports, signals emerged that inflation is easing and that the worst may be over for corporate profits. In fact, stronger-than-expected results for some companies prompted analysts to raise forecasts for industries that will benefit from faster economic growth, such as semiconductor manufacturing and homebuilding, BI data show.

4. What effect is this having on the stock market?

Anticipation that the worst has past is fueling an equities rebound. Stock markets are forward-looking, with investors anticipating what’s going to happen at least six-to-12 months from now. Expected profits are typically the most important metric, more important than projections for economic growth. After sliding 19% in 2022, the biggest drop since 2008, the S&P 500 advanced 19% from Jan. 1 to July 18, pushing above the key 4,500 level. That’s already much higher than the average full-year gain predicted by a survey of two dozen analysts published June 15, which forecast that the index would end the year at 4,091. 

—With assistance from Lu Wang.

This article was provided by Bloomberg News.