Earnings are under threat, another blow to the flagging stock market

Stocks have fallen this year amid rising interest rates. With inflation showing little sign of slowing down, many investors are concerned that corporate earnings could be the market’s next falling mainstay.

The S&P 500 is down 18% in 2022, its worst start to a year since 1962, as the Federal Reserve embarks on a rate hike campaign to bring down four decades of high inflation. Monetary tightening trampled on highly valued stocks earlier in the year, making earnings growth a key pillar for the market to regain its footing.

However, the past few days have cast doubt on the sustainability of corporate earnings growth, further clouding the outlook for equities. Target Corp company.

TGT -3.16%

to Microsoft corp

MSFT -4.46%

have warned their results will come in lower than expected, while analysts have cut earnings forecasts across sectors. Investors will get further clarity next month when companies start reporting their second-quarter results.

US companies face challenges on several fronts. Target’s warning points to shifts in consumer tastes that have left retailers with excess inventory. Microsoft, on the other hand, warned that the stronger dollar would eat away at its profits. The WSJ Dollar Index, which measures the dollar against a basket of 16 currencies, is up 8% this year.

As the dollar rises, Americans see their money going further as they buy overseas goods and services. But American products are also becoming less affordable for foreigners, hurting international sales for all types of businesses. Technology companies, pharmaceutical companies that sell medical products in international markets, and manufacturers with large export markets are among those vulnerable to the impact of a rising dollar.

Meanwhile, Friday’s consumer inflation data hit another four-decade high in May, dashed hopes that easing price pressures would allow the central bank to ease. Instead, federal fund futures show that traders are increasing their expectations for higher interest rates. Separately, preliminary results from the University of Michigan showed that US consumer sentiment fell to its lowest level on record in June, an ominous sign of economic growth.

The disappointments drove stocks lower, with the S&P 500 ending its worst two-week decline since March 2020.

With inflation still scorching hot and the Fed potentially tightening tightening, investors may decide that valuations still look stretched as corporate earnings come under pressure.

Investors will be watching the Fed’s monetary policy meeting this week, where officials are expected to hike interest rates again by half a percentage point. They will also examine data on producer prices and retail sales while monitoring the course of inflation and consumer health.

Some analysts have warned that the market’s earnings expectations are too high.

“Our overall view is that the bear market isn’t over yet because these earnings numbers need to come down now,” said Michael Wilson, Morgan Stanley’s chief US equity strategist and chief investment officer.

“We don’t think the sell-off is over.”

Mr. Wilson and his colleagues wrote in a recent note that they expect a hawkish central bank and falling earnings expectations to pull the S&P 500 towards 3400 by mid to late August — a 13% drop from Friday’s close.

The rapid move away from near-zero interest rates has penalized stock trading with high valuations and made the market overall cheaper than in the recent past.

The S&P 500 was trading at just under 17 times its forecast earnings for the next 12 months late last week, up from 21.5 times late last year, according to FactSet. The current multiple is roughly in line with its 10-year moving average, suggesting that many investors still don’t think stocks are cheap.

Robust earnings growth had supported stocks during the recent turmoil. With nearly all S&P 500 companies reporting, analysts are forecasting first-quarter earnings rose 9.2% year over year, according to FactSet. Full-year 2022 earnings growth is forecast at 10%.

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In the early stages of the current wave of inflation, many companies were able to pass higher costs on to consumers through price increases. According to FactSet, analysts expect the S&P 500’s first-quarter net income margin to be 12.3%, up from the five-year average of 11.1%.

There are signs that those days may be numbered.

Recently, high-profile examples of costs squeezing corporate profits have rocked the market. Walmart Inc.

WMT 0.56%

Shares fell 11% in a single day last month after the retail giant said higher product, supply chain and employee costs hurt its profits. Target shares plunged 25% the following day after the company said it would absorb increased costs this year rather than hike prices.

“Time is no friend of profit margins in an inflationary environment,” said David Donabedian, chief investment officer at CIBC Private Wealth US. “At some point, your customers will no longer be willing to pay the next price increase.”

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Less than three weeks after releasing those results, Target returned to the spotlight last week to warn that its profit would fall this year as it offers rebates and cancels supplier orders to try to shed excess inventory. Meanwhile, earlier this month Microsoft lowered its earnings guidance for the current quarter, citing the impact of a stronger US dollar. Foreclosure inc

also recently cited the stronger dollar to lower its sales outlook for the year.

Earnings expectations have fallen overall for large US companies. According to FactSet, analysts now expect earnings for S&P 500 companies to rise 4% in the second quarter, compared to April 22 estimates of 6.6% growth. Forecasts for third-quarter earnings growth fell to 10.6% from 11.4% over the same period, while forecasts for the fourth quarter fell to 10.1% from 10.9%.

Not everyone is concerned about earnings. Stephanie Lang, chief investment officer at wealth management firm Homrich Berg, said the market may be able to turn higher once earnings forecasts stabilize.

“If you go ahead and make the effort now, companies will be better positioned to meet future earnings expectations,” she said.

Write to Karen Langley at karen.langley@wsj.com

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