[Insight & Opinion] Finding Undervalued Opportunities in High-Quality Assets Amid the Path to Recession

Period of Economic Recession and Corporate Earnings Contraction
A Time for Investors to Seek Opportunities
Assessing the Intrinsic Value of High-Quality Companies

Along with the global economy next year, the Korean economy is also expected to face concerns over recession and financial vulnerability. Korea's GDP growth rate is projected to decline from 2.2% this year to 1.5% next year, indicating contraction, while the consumer price inflation rate is expected to ease from 5.2% to 3.5% but remain elevated. Next year, the economies of the U.S., Europe, China, and emerging markets are anticipated to enter recession with short time lags, leading to a contraction in trade. Following the export decline that began in the second half of 2022, domestic demand?which had shown recovery after the pandemic?will also contract starting in 2023. Although inflationary pressures from domestic demand are easing, public utility rate hikes and global supply disruptions as external factors will sustain high inflation for a considerable period. Ultimately, economic activity will stagnate, the financial conditions of economic agents will deteriorate, and there are concerns over worsening macroeconomic and external soundness, including inflation, currency depreciation, and trade deficits.

The global real economy is expected to experience a double-dip recession. Next year, recession in Europe and the U.S. will reduce trade and increase unemployment, and in 2024, the prolonged financial market deterioration and recession over two years will lead to declines in private consumption and investment. In other words, a full-fledged downcycle in the real economy is likely to begin from next year. When a recession occurs, corporate earnings also contract. From a macroeconomic perspective, inputs, outputs, and production decrease, while from a corporate activity perspective, sales and transactions decline. Amid this, the costs of production factors (labor and capital) and financial costs remain high, making a decline in corporate earnings inevitable.

Since the 1950s, the U.S. has experienced about 12 recessions, during which corporate earnings have invariably declined. Moreover, the rate of decline in corporate earnings has been greater than that of real GDP, and the duration of earnings decline has been longer than the recession period itself. Notably, during periods of high inflation like the 1970s and 1980s, recessions and corporate earnings downturns did not end with a single shock but involved a second shock, i.e., a double dip. In the case of the 2008 financial crisis, initial inflationary pressures were high, but after the financial crisis and recession, a rapid shift to deflation occurred, preventing a second recession; however, the decline in corporate earnings exceeded -30%, marking the largest drop on record.

In the second and third quarters of this year, U.S. companies’ pre-tax profits after inventory revaluation and capital adjustments reached record highs (Q2: $3 trillion; Q3: $2.97 trillion), showing strong performance. Despite rising inflation, profits remained robust as sales did not decline due to price pass-through. However, once the full impact of the recession sets in next year, declines in sales and profits will be unavoidable. From now on, economic agents’ expectations and behaviors will lead them to reduce consumption and investment in preparation for the forthcoming economic slowdown or recession. If companies fail to cut costs amid declining sales and profits, profitability will worsen further. Since the extent and duration of the upcoming recession are uncertain, it is also difficult to predict the magnitude and length of corporate earnings contraction at this time. What is clear is that recession and corporate earnings downturn are about to begin.

However, given the current prolonged market correction, the period of recession and corporate earnings contraction in 2023 may present an opportunity for investors. This is because it will be a chance to gauge which companies maintain stable earnings in a recessionary environment, what choices they make to secure long-term growth, how the market evaluates them, and what actual earnings they deliver. Amid the 2023 recession and corporate earnings downturn phase and ongoing adjustments in financial and capital markets, a phase will emerge where high-quality companies are undervalued relative to their intrinsic value. Therefore, 2023 will be a good time to purchase stocks or bonds of high-quality companies whose corporate value is undervalued.

Dongmin Lim, Economist at Kyobo Securities