Margins under pressure as recession looms

3 min read 16 Dec 22

Summary: Equities rallied in November as the relaxation of China’s zero-Covid policy and signs of moderating inflation boosted investor sentiment. However, as we look ahead to 2023, what are the potential implications of a tougher economic environment on both consumer behaviour and corporate profit margins? Investment Specialist, Kirsty Clark reviews recent market performance and looks at the potential impacts of a deteriorating global outlook. 

Equity markets gained ground in November with a relaxation of China’s zero-Covid policy boosting Asia ex Japan and Emerging Market equities, while developed market equities rallied following signs of moderating inflation. The MSCI AC World Index was up 7.8% in US dollar terms, but remains down 15% year to date. Value marginally outperformed growth, with the exception of Emerging Market large caps where growth stocks pulled ahead of value names. Large caps were typically more resilient than their smaller cap counterparts.

Source: Refinitiv DataStream, 30 November 2022. Total Returns in USD.


Asia ex Japan and Emerging market equities led the market gains in November, with a strong rally in Chinese equities lifting the regional returns. UK, Eurozone and Japanese equities also outperformed in USD terms. US equities were the laggards in the month.

Semiconductors led the returns at sector level, along with materials and insurance. Energy underperformed but remains the best performing sector year to date.

In fixed income markets we saw a correlated rally with equities, with government bonds, investment grade credit and high yield delivering positive returns. The yield in US 30-year treasuries fell more than 60 basis points from the high in October through to the end of November.

It was a mixed bag in commodities markets. Gold and copper rallied while oil prices fell leaving Brent crude and WTI down in the month. The broader CRB Commodities Index was up overall in November. In currency markets, the US dollar weakened against sterling, the euro and the yen.

Despite the recent risk-on sentiment, as macroeconomic data continues to soften, the prospect of recession looms. As we head into 2023, this could create a more challenging environment for corporate profit margins.

Net profit margins have remained relatively resilient to date, amid rising costs, as many companies have been able to pass price hikes on to end consumers, but we have started to see some weakening in recent months.

Source: Refinitiv Eikon, Worldscope, 1 December 2022


Earnings have been buoyed by excess household savings, a post-covid demand boost and labour market strength, but higher costs will be tougher to pass on in a recessionary environment.

The personal saving rate (savings as a percentage of disposable income) in both the US and Europe is now running at, or below, pre-Covid levels as consumers have run down excess savings post lockdowns, while inflation is eating into real wage growth. These factors combined weigh on consumers’ purchasing power and have to potential to reduce their propensity to spend. 

Source: LHS Chart: Refinitiv Eikon, 15 August 2022. RHS Chart: Bloomberg, 30 November 2022.
 

Earnings have been buoyed by excess household savings, a post-covid demand boost and labour market strength, but higher costs will be tougher to pass on in a recessionary environment.

The personal saving rate (savings as a percentage of disposable income) in both the US and Europe is now running at, or below, pre-Covid levels as consumers have run down excess savings post lockdowns, while inflation is eating into real wage growth. These factors combined weigh on consumers’ purchasing power and have to potential to reduce their propensity to spend. 

Just as a demand slowdown has the capacity to hit companies’ top line in 2023, the rising rate environment – and subsequent increase in the cost of capital – could increase the cost burden for companies, putting a further squeeze on net income.

So while the corporate sector at large remains in decent shape, and many companies continue to report strong pricing power, softening demand and a rising cost of debt will likely see corporate margins come under increasing pressure in 2023.

Companies may yet prove more resilient than expected, but much will depend on the depth and longevity of recession, and how successfully central banks can tame inflation while avoiding the worst economic outcomes.

As our CIO Equities, Multi Asset and Sustainability points out in the recent 2023 Investment Perspectives update, this is still a market in which active investors can find attractive opportunities but, with companies being affected in very disparate ways by a multitude of factors, it is not a market for broad strokes investing. Selectivity and diversification remain key, along with a focus on companies with robust balance sheets and strong pricing power. 

The value of investments will fluctuate, which will cause prices to fall as well as rise and you may not get back the original amount you invested. Past performance is not a guide to future performance.

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