Is an earnings recession inevitable and if so, how long will it impact investment markets?

July saw something of a recovery in investment markets with the all ords improving by more than 5% from its low in June.

Whilst this was good news, in light of all the headlines around inflation and rising interest rates, it’s far too early to tell whether the recovery is sustainable.

In fact, the headlines have moved on from whether the rapidly increasing interest rates will cause a recession, to if there is a recession (particularly in the states), will it cause an earnings recession. That is, will company profits start to shrink and in doing so, prolong the current period of volatility.

Interestingly, it was only a few weeks ago that punters were suggesting that if the U.S. Federal Reserve were to raise interest rates by 0.75%, then markets would drop even further. Well they did just that last week, and the markets saw it as a positive sign, and had a couple of very strong days thereafter.

The significance is that markets have become seemingly more resilient of late and strong action by the fed – a 0.75% rise in interest rates – is now perceived as responsible and necessary.

There is also a perception (and that’s all it is at this time) that inflation has peaked and will start to drift down over the course of the next few months.

Now that may well be the case, but the potential damage to company earnings may already be in train. And company earnings are one of the main drivers of share markets. The damage being that some of the economic data coming through, has recently turned negative. Economic growth has slowed, consumer confidence has dropped and existing home sales have dropped.

However, it isn’t all bad news. J.P. Morgan, the U.S. investment house, recently posted an article showing the median return from investment markets, following a recession. The return on the whole was quite positive, despite a decline in earnings during the recession and immediately following.

It’s hard to explain why this might be the case, except markets do tend to look forward. And the Fed’s action to raise interest rates so aggressively, might be seen as positive for the longer term. Short term pain for long term gain.

So whilst initial criticism that the Fed were a little late to the party in raising interest rates, they would appear to have made up for it in the last couple of months and markets have responded positively.

However, it’s hard to say whether the markets will continue to improve from here, or whether the trend of declining company earnings will produce further volatility. J.P. Morgan’s view is that history is no indication of the future but it does have some relevance. Whilst they posit that there might be an economic recession, they do not expect there to be an earnings recession. Which, assuming they are right, and history is on their side, might be the catalyst to turn markets around.

By Jamie Luxton

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