Watch out for this sneaky earnings killer, Morgan Stanley warns

An economic slowdown that triggered a tsunami of unsold inventory at various companies may have proved lethal for corporate America's third-quarter earnings and, soon, forward guidance.

At least, that's what the strategy team at Morgan Stanley warned in a new note out on Monday.

"Our U.S. Equity Strategy team sees inventory as a key risk to earnings — oversupply and lagging demand are likely to weigh on margins," the note stated. "The problem with inventory is twofold — supply chain bottlenecks are clearing while demand, especially demand for goods, is slowing."

"We expect overall demand to slow beyond the payback in overconsumption of goods as sentiment remains weak and inflation weighs on consumers," the strategists continued. "Increasing supply and falling demand is likely to spark discounting adding fuel to the earnings slowdown we are calling for. The inventory problem is upon us for publicly traded companies."

The investment bank lists a host of companies with above-average inventory risk looking out over the next few quarters, including Ford (F), Abercrombie & Fitch (ANF), Gap (GPS), Carvana (CVNA), Best Buy (BBY), and Micron (MU).

Bloated inventories (which often lead to the need for profit-busting markdowns), a strong dollar, stubborn inflation, and a host of other factors have set the stage for an ugly earnings season kicking off this week.

Wall Street analysts expect 3% year-over-year EPS growth for S&P 500 companies for the third quarter, 13% sales growth, and 75 basis points of margin contraction to 11.8%, according to data crunched by Goldman Sachs. Just several months ago, analysts were anticipating 10% EPS growth for the third quarter for S&P 500 companies.

Excluding the energy sector (which has seen posting triple-digit profit growth), EPS is expected to fall by 3% and margins are projected to contract by 132 basis points.

Goldman Sachs Chief U.S. Equity Strategist David Kostin echoed Morgan Stanley's inventory concerns heading into the earnings season.

"The health of the consumer is a focus for investors because the combination of softening demand and excess inventory will limit the ability of some firms to raise prices," Kostin wrote in a new note to clients. "The ISM Manufacturing index in September fell by more than expected to 50.9, the lowest level since May 2020, as manufacturers struggled with a surplus of inventory. Target's inventory is a concern for investors and Nike recently lowered its 2023 gross margin forecast due to the need to pursue aggressive discounts. Although our retail analyst views this development as a supply-chain driven timing issue, an inventory glut will weigh on margins if the macro environment deteriorates."

Brian Sozzi is an editor-at-large and anchor at Yahoo Finance. Follow Sozzi on Twitter @BrianSozzi and on LinkedIn.

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