3 reasons a key driver of stock-market performance is weakening, JPMorgan says

• A key driver of stock market performance is set to weaken for 3 reasons, according to JPMorgan.
• The bank said corporate profit margins face headwinds and have likely hit a peak.

The main driver behind stock market performance is set to weaken going forward, according to JPMorgan.

The bank offered three reasons corporate profit margins are set to fall in a note on Monday, even if an economic recession doesn't materialize. Such a scenario would mean that stock price are also set to decline.

"Corporate profit margins are elevated in a historical context, and appear to be peaking out. The historical pattern where profit margins always start to move lower ahead of the next economic downturn is clear," JPMorgan equity strategist Mislav Matejka said.

What's worrying Matejka is threefold.

First, the impact of soaring interest rates in 2022 and 2023 have yet to negatively impact most businesses because they took advantage of low interest rates and raised long-term fixed-rate debt before the Federal Reserve's interest rate hikes. On top of that, companies with high cash balances saw a benefit from higher interest rates.

But this is set to normalize as corporate debt eventually gets refinanced at higher interest rates.

"This, rather counter-intuitive, development is set to normalize as time passes. Companies will have to roll their debt into higher cost of credit," Matejka said.

Second, Matejka highlighted that high rates of inflation in 2022 and 2023 allowed companies to raise their prices considerably, leading to outsize revenue growth. But that pricing power is set to end as inflation is reined in, and that means slower growth for companies.

"We are still of the view that COVID induced inflation spike will end up fully unwound, and this in turn suggests that corporate profitability winners need to be reset," Matejka said.

Third, the overall economy is set to see decelerated growth from what was a stronger-than-expected 2023, according to Matejka, and that means corporate profits should also slow.

"If the economy slows, partly because the supports that it enjoyed last year do not repeat, such as fiscal stimulus, ULCs could pick up," Matejka said, referring to unit labor costs. And if labor costs rise, profit margins fall.

"Putting the above 3 together, one might end up with a disappointing profits outcome even without seeing an outright recession, and we note that 2024 EPS [earnings per share] projections keep coming down in key regions," Matejka said.

JPMorgan remains one of the most bearish firms on Wall Street, with a year-end S&P 500 price target of 4,200, representing potential downside of 17% from current levels.