Optimism around soft landings risks colliding with slower profit growth.
Equity markets have grown increasingly confident that the economy can decelerate without meaningful damage to corporate profits. That assumption underpins current valuations, with investors largely focused on inflation progress and interest-rate stability. What appears less fully priced is the possibility that earnings growth itself may enter a more challenging phase, even in the absence of a recession.
The S&P 500’s strength, as reflected in the SPDR S&P 500 ETF Trust (SPY), has been driven more by multiple expansion and leadership from a narrow set of large-cap companies than by broad-based profit acceleration. Outside those leaders, many firms are contending with margin pressure from higher labor costs, tighter credit conditions, and consumers who are becoming more selective in their spending.
This dynamic is particularly visible in cyclical sectors. Industrials and consumer discretionary companies benefited from post-pandemic demand normalization, but that tailwind is fading. Firms such as Home Depot (HD) are seeing slower volume growth as higher financing costs dampen big-ticket purchases. While revenue declines have been modest, the risk lies in operating leverage: even small demand shortfalls can have outsized effects on earnings.
Cost control has so far cushioned the impact. Many companies entered this period leaner, having restructured during prior downturns. However, productivity gains are harder to extract over time, and wage growth remains sticky. If pricing power weakens, margins could compress more quickly than markets anticipate.
None of this implies an imminent earnings collapse. Balance sheets are generally healthier than in past late-cycle periods, and demand remains supported by employment levels that are historically strong. But the gap between optimistic earnings expectations and a slowing economic reality leaves little room for disappointment.
For investors, the next phase of the market may hinge less on macro relief and more on micro execution. Companies that can grow profits without relying on expanding multiples are likely to stand out. The broader market, however, may discover that avoiding a recession does not guarantee a smooth earnings cycle—and that distinction could matter more than investors currently expect.
