Corporate America is facing its sharpest drop in profits since the early stages of the Covid pandemic, according to Wall Street forecasts, as high inflation squeezes margins and fears of an impending recession hold back demand.

Companies on the S&P 500 index are expected to report a 6.8 per cent decline in first-quarter earnings compared with the same period a year earlier, according to analyst estimates compiled by FactSet. That would be the biggest fall since the more than 30 per cent plunge in the second quarter of 2020, which came as the rapid spread of coronavirus led to a widespread economic shutdown.

Ahead of the first-quarter earnings season, which begins with a trio of big banks reporting results on Friday, sectors such as energy and consumer discretionary are expected to show strong year-over-year profit growth. However, a combination of flagging consumer demand, tighter credit conditions, and a downswing in commodity prices has cut into earnings expectations across a broad spectrum of industries.

“When you look at the cost of wages and the cost of capital I think margins are coming under a fair amount of pressure,” said Jack Ablin, chief investment officer at Cresset Capital. “Companies were enjoying nominal growth, they had some pricing power, but their volumes were either shrinking or just staying the same.”

The gloomy outlook among Wall Street analysts belies a relatively buoyant market, with the S&P up more than 6 per cent since the start of the year. Still, just 20 stocks have accounted for almost 90 per cent of that rise. Falling interest rate expectations have boosted the appeal of some of the biggest technology companies, a development that has masked a more lacklustre performance from the wider stock market.

Analysts had higher expectations ahead of the quarter, forecasting a 0.3 per cent dip in profits on December 31. While earnings forecasts typically decline over a quarter, they did so more than as much as the average over the past five years during the opening three months of 2023. Only the utilities sector finished the quarter with higher expectations than it started with.

More companies than usual signalled weakness in the first quarter, with 78 issuing negative guidance on their earnings per share — an indication that management expects to miss analysts’ forecasts — exceeding the five-year average by 37 per cent. The semiconductors industry, a part of the broader information technology sector, provided 11 such warnings.

Of the 11 sectors in the S&P 500, materials is expected to take the worst earnings hit, with a 35.6 per cent decline forecast.

“Normally you see materials prices and profits swing in anticipation of a recession,” said Brad McMillan, chief investment officer at Commonwealth Financial Network. “Companies are cutting back in anticipation of slower sales going forward.” 

New orders for durable goods in the US fell for the second month in a row in February, while analysts had expected a rebound in buying.

As goods purchases slow, an uptick in services spending is expected to make the consumer discretionary sector the top performer in the quarter at 34 per cent earnings growth, driven by strength in hospitality-related industries. Profit growth in the airlines industry is expected to make the industrials sector second-best at 12.6 per cent.

Despite the recent turmoil in the US banking industry, the financials sector is expected to report a 2.4 per cent increase in profit, and lead all sectors in revenue growth at 9.1 per cent, compared to the 1.8 per cent average. Citigroup, Wells Fargo and JPMorgan Chase all report first-quarter results on Friday before the market open.

“Since recent bank failures happened in the last few weeks of the quarter, the full impact won’t register in first quarter reports” Goldman Sachs analysts wrote in a note to clients.

But the failure of three banks this year could put pressure on small and medium-sized businesses for the rest of 2023, according to Ablin.

Unlike large companies that have “pretty much unfettered access” to capital, “I think the middle and small companies will likely be increasingly disadvantaged by tightening credit,” he said.