By Monica Johnson, International Banker
It was only a little over a year ago that the United States saw its stock markets roaring to record highs, with the benchmark S&P 500 (Standard and Poor’s 500) almost hitting 4,800 at the start of 2022. What’s more, that period saw bond yields trading at around 1.5 percent—near all-time lows—and the Federal Reserve (the Fed) managing to keep its benchmark interest rate at a low of 0 to 0.25 percent as the rising inflation at the time was still considered to be a “transitory” trend. Oh, how times have changed since those halcyon days.
As it turned out, inflation was far from transitory, as was painfully demonstrated by the steep interest-rate hikes the Fed and many other central banks soon implemented as they scrambled to bring down inflation, which in some countries skyrocketed to double digits. And with Russian troops crossing into Ukrainian territory in late February only compounding matters, markets turned highly volatile as bearish sentiment grew amid a deteriorating market environment. As for US equities, 2022 ended up being a year to forget. The S&P 500 lost almost 20 percent over the 12 months as persistent inflation, sharply rising interest rates, a surging US dollar and growing fears of a deep and prolonged recession all conspired to trigger a broad equity market sell-off, the magnitude of which had not been seen since the 2008 Global Financial Crisis (GFC).
But what investors want to know is whether there will be more of the same gloom in 2023—or will US stocks escape the bear market and post a sustained recovery? Following January’s performance, in which the S&P 500 posted respectable gains of around 7 percent after the Fed slowed its pace of rate hikes in December and then followed up with a 25-basis-points (bps) rise at its February 1 meeting, one might be inclined to suggest the latter scenario is more probable. Indeed, bullish investors may well point to the slowing pace of rate hikes and the gradual easing of inflation as justification for believing 2023 will be a fruitful year for US equity markets. And should the Fed be skillful enough to bring inflation in line with its 2-percent target whilst preventing the economy from tipping into recession and corporate profits from significantly eroding, US stocks may even thrive this year.
Analysts also express moderate optimism over corporate earnings, particularly for the year’s final six months. Although the consensus of S&P analysts’ estimates in early February indicated a decline in corporate earnings of 4.2 percent and 2.9 percent during the first and second quarters of the year, respectively, the third and fourth quarters will experience earnings growth of 3.4 percent and 10.5 percent, respectively, while the whole year will see earnings grow by a respectable 3.0 percent to almost $230 per share.
But with mid-January’s release of fourth-quarter 2022 earnings showing that S&P 500 companies suffered a 5-percent annual decline in earnings per share—the first negative reading for the index since the third quarter of 2020—some believe those analysts’ predictions to be too optimistic, including Morgan Stanley’s Global Investment Committee, which has stated that it “disagrees” with such bullishness. “We expect corporate sales volumes and pricing power to deteriorate, leading to profit declines, even without a recession, hence our lower earnings estimate of $195 per share for 2023,” Lisa Shalett, chief investment officer of the Morgan Stanley Wealth Management division, wrote in mid-January. “When we consider factors such as the Purchasing Managers’ Index (PMI) data, the yield curve and correlations between profit growth and the speed of the Fed’s rate hikes, we anticipate that 2023 year-over-year earnings growth will likely be materially negative.”
Indeed, several outlets are now warning that equities are again in for a rough ride this year, although much will ultimately depend on whether the US falls into a recession later in the year. J.P. Morgan, for example, expects earnings to be roughly flat relative to 2022 levels should a recession be avoided. “However, if the US economy falls into recession, history suggests earnings could decline by as much as 15-20 percent,” David M. Lebovitz, global market strategist on the J.P. Morgan Asset Management Global Market Insights Strategy Team, recently projected. “Perversely, stubborn inflation could support earnings. With inflation only gradually decelerating, rising prices will continue to offset higher costs in certain industries, leaving margins as the key driver of earnings. While margins will continue to decline, they should settle around 10 percent, rather than falling to the long-term average.”
With 2-year government bond yields trading above the 10-year through much of 2023 to date, moreover, bond markets are forecasting a recession in the not-too-distant future that would prompt the Fed to lower interest rates later in the year. This inversion also starkly contrasts those analysts’ estimates that suggest earnings will continue to rise. According to a recent analysis from Lazard Asset Management, one or both of these markets may prove inaccurate. “If recession is avoided, that means interest rates will likely remain higher for longer, which in turn means we will see higher bond yields and lower multiples on stocks (due to higher discount rates on future earnings),” Lazard noted in its “January 2023 Outlook on the United States”. “If the economy does slide into recession, earnings expectations are likely to decline, perhaps materially, which means lower share prices.”
Lazard, expecting a mild recession to transpire, sees the likely outcome as somewhere between the two markets’ outlooks, as the implied forward valuation for the S&P 500 in earnings multiples for this year is lower than that of Moody’s Baa Corporate Bond Index. “Historically, the last time equities traded for a sustained period of time with a lower earnings yield, or a higher multiple, than the Moody’s Baa Corporate Bond Index was in 2002 in the aftermath of the telecom bubble,” Lazard added. “We would argue that this is not a time when one can easily justify a lower earnings yield on equities than on the lowest rung of investment-grade corporate bonds. As such, we enter 2023 with a negative view on the ‘equity market.’”
It is also worth reminding ourselves that, at this stage, inflation remains far from being the slain enemy for which most of us are waiting. As such, any expectations that the US economy will achieve a soft landing later this year should be tempered for the time being, as the coming few months may well be the Fed’s most critical stage in its battle to stabilise prices without triggering a recession. The benchmark inflation measure saw prices in December rise at a brisk 6.5 percent year-on-year; while this may be down from last June’s 9.1-percent peak, it remains some distance away from the Fed’s 2-percent target.
And it is worth noting that January’s positive month for equities came despite the Fed’s Beige Book report on the economic situation during the month, which warned that US businesses “generally expected little growth in the months ahead”. According to Richard Saperstein, chief investment officer at Treasury Partners, the stock market and the economy remain in precarious positions. “Markets have been reacting favorably to moderating inflation and expectations of a reduced pace of Fed tightening, but the lag effects of the Fed’s tightening so far will slow the economy in the second half of 2023 and cause analysts to slash earnings estimates, which ultimately is a headwind for stocks,” said Saperstein, as quoted in a February 1 Forbes article.
Much remains up in the air regarding how much volatility US stock markets will experience this year as a heady combination of key systemic factors is likely to persist over the coming months, despite having probably already peaked. “Although the outlook for risk assets is improving, plenty of questions remain unanswered. We have seen peak inflation, peak Fed hawkishness and (hopefully) peak geopolitical tensions, but these issues have not gone away and will remain as a source of volatility,” J.P. Morgan noted. “However, if we do experience a mild recession next year, markets will begin to look to the coming cycle well in advance of the economic data improving…. As such, there is light at the end of the tunnel, but it is not clear how long the tunnel might be. Until we have that clarity, we prefer companies with pricing power and consistent cash flows that are trading at reasonable valuations.”