Stocks May Struggle Even with a Soft Landing

There is no consensus among economists about what will happen to the economy in the new year. Some believe that the U.S. will experience a mild recession, while others think that the economy will be able to avoid a downturn.

For most Americans, neither outcome would be particularly bad, especially if, as many economists believe, the job market doesn't suffer much. But for many of the companies that dominate the U.S. stock market, even a soft landing could be quite painful.

In an effort to combat inflation, Federal Reserve policy makers have raised rates sharply over the past year, taking the midpoint of their overnight target range from 0.125% to 4.374%. They aim to keep raising rates in the months ahead in order to keep inflation in check. However, these rate increases can have a negative effect on the economy, as they make borrowing more expensive and can lead to a slowdown in economic activity. Additionally, other central banks around the world are also raising rates, which can create additional drag on the U.S. economy.

There is a chance that severe job losses might not occur during an economic downturn, as many businesses are still desperate for workers. Additionally, even though inflation has eroded spending power for many Americans, they are still in better financial shape overall than before the pandemic. Finally, with the economy slowing and inflation starting to cool, economists and investors believe that the Federal Reserve will not raise interest rates as much as currently forecast, and may even lower rates by the end of the year.

Economists at Goldman Sachs, Morgan Stanley and Credit Suisse are among those who think the U.S. will avoid a recession, while economists at Bank of America, JPMorgan Chase and Barclays are forecasting mild recessions. However, economic forecasts need to be taken with a fair amount of skepticism, and the unusual circumstances of the pandemic have made that even more true. But imagine for a moment that the economists have got it broadly right. What might that mean for the companies represented in the stock market?

It is important to remember that the pandemic has been good for big companies' businesses. Industry analysts estimate that S&P 500 companies' sales per share will be 24% higher in 2022 than in 2019. This is a significant increase even after taking inflation into account. For comparison, gross domestic product in the United States is expected to be 19% higher in 2022 than in 2019, unadjusted for inflation.

A big reason why S&P sales have outpaced the economy is that a lot of S&P 500 companies are in the business of selling what people bought more of during the pandemic. Much more than the economy itself, the index is geared toward producers and purveyors of goods—by both market value and sales, manufacturers and retailers account for about half the index. In contrast, those sectors account for only about a fifth of U.S. gross output. So as people stocked up on items such as sofas and washing machines, and stayed home rather than spend money on services such as travel and dentist visits, many S&P 500 companies benefited. And some of the services they did shell out more for, such as streaming services, also benefited public companies.

Now people are re-engaging in services such as tourism, haircuts and dentist visits, which is good for the economy. However, this also means that spending on goods could fall sharply. For example, if spending on services grows by 3% but spending on goods doesn't grow at all, spending on goods would need to fall by 5.8%. The multinational nature of many big public companies makes the situation even worse, since many countries are in far worse shape than the U.S.

Further compounding the problem, some public companies may have difficulty cutting labor costs because in a job market where services companies are eager to add workers, hiring back laid-off employees could be difficult. So in addition to revenues coming under pressure, maintaining profit margins could be even more difficult than usual. This could make it difficult for public companies to compete in the current market.

It is too early for investors to start counting on a soft landing or mild recession to help public companies weather the Fed's inflation fight. While a more severe downturn would certainly be worse for sales and profits, the job market may be able to weather the Fed's inflation fight. If so, sales and profits will be primed to grow again when the central bank eases off.