Wall Street Is Missing The Risk To Stocks If Inflation Is Beaten

A conventional belief among stock bulls is that prices will rise when the Federal Reserve defeats inflation. It is possible, however, that another round of bad news may be unleashed as a result of the end of surging consumer costs. In recent months, a small chorus of researchers has warned that the campaign to tamp inflation may damage earnings. Specifically, the squeeze on margins that could occur should an indicator known as corporate operating leverage suffer in an environment where sales flatten out. The indicator represents the difference between a company’s fixed and variable costs. When a company’s costs remain high but cannot offset them by raising prices because of low demand, it can turn negative in the aftermath of peak inflation.

While earnings held up surprisingly well throughout the pandemic and powered a number of bear market rallies, a fall in operating leverage may prove to be the final hazard that leads to stock market lows, according to a Morgan Stanley team led by Mike Wilson. “Thinking about the areas of inflation that are likely to remain more resilient into next year (shelter, wages, certain services) and the areas that are likely to decelerate (goods) does not paint a constructive picture for S&P 500 margins, in our view,” Wilson, one of Wall Street’s biggest equity bears, wrote in a recent note to clients. According to his team, operating leverage, calculated by subtracting sales growth from earnings per share growth, is unlikely to remain positive in the coming quarters. Even though he is one of many sell-side analysts concerned about a margin contraction, consensus estimates for next year remain positive. According to equity analysts, earnings for the first quarter of 2023 are expected to increase by 5.56%, while sales are expected to increase by 5.48%. The pattern currently holds for the full year 2023 as well: earnings are anticipated to rise more than sales as operating leverage remains positive.