Earnings are the stock market's Achilles' heel, and investors are not pricing in the risk of a recession yet, Barclays says

• Stocks will struggle through 2023 as valuations and consensus earnings estimates are "disconnected" from fundamentals, according to Barclays.
• It has a 2022 S&P 500 price target of 3,200, representing 13% downside based on Tuesday's intraday action.

Wall Street's view of 2023 corporate earnings growth is lofty, which will contribute to an ongoing search for the bottom in stocks, Barclays said.

Earnings are the market's Achilles heel, with the consensus view too optimistic in the face of a worsening economic outlook, especially outside of the US, the bank said in a research note Monday. Risks to profit include consumers pulling back goods spending and margins contracting because of sticky costs and wage pressures.

Equities will struggle through 2023 as valuations and consensus earnings estimates are "disconnected" from fundamentals, Barclays predicted. The S&P 500 in 2022 could drop by another 13% to 3,200 based on Tuesday's action with the index moving around 3,700. Its 2023 price target is 3,675.

"Bottom line, earnings estimates remain too high, in our view, whether we have a recession or not. A recession will simply expedite the revision cycle and get us to the trough sooner. We think earnings disappointment is likely to drive the next leg lower in stocks," said Venu Krishna, Barclays's head of US equity strategy.

Barclays' S&P 500 earnings estimates for 2022 and 2023 are 2% and 12% below consensus, at $221 per share and $210 per share, respectively.

The Federal Reserve and other central banks have been raising interest rates to control inflation, which in the US was at a 40-year high as core consumer prices were up 6.6% in September.

"Be careful what you wish for… Falling inflation will be bad for earnings," said Krishna, noting that an increase in inflation has served as a strong tailwind for corporate profits and margins since 2020, while a slowdown in prices will act as a headwind.

"We think consensus estimates are underestimating the negative operating leverage of falling inflation, much as they underestimated the positive operating leverage as inflation rose. As demand eases, we expect the pricing power of corporates to fade with falling inflation," Krishna wrote.

Rising inflation and the Fed's response to it with aggressive rate hikes have kept pressure on equities this year, pushing the S&P 500 and the Nasdaq Composite each into a bear market.

The S&P 500 price-to-earnings ratio at 15.5x is closer to Barclays' fair value estimate of 14x. However, investors are not still discounting the earnings damage that will stem from the current slowdown in growth, "let alone the risk of a recession," it said.