U.S. Equities: Valuation or Earnings?
View change: We are less certain that a downward reset of 2023 corporate earnings expectations will occur by end-2022, due to recent data trends. Thus we are revising up our end-year forecast for the S&P500 to 3,750 from 3,650, though we are still bearish as we feel that enough economic weakness will be evident to hurt the market — while 10yr real yields will likely remain stable and not provide any benefit as they did in July and August.
Figure 1: 10yr U.S. Real Treasury Yield Inverted and Forward S&P500 P/E Ratio (% rhs)
Source: Datastream, Continuum Economics using breakeven inflation from index-linked bonds
Valuations or Earnings Outlook
The bounce in U.S. equities since the start of July has been driven by short covering, speculative buying and some institutional bottom picking after a torrid H1. From a more fundamental perspective, the big driver has been the rise in yields in nominal and real terms in H1 and then the partial reversal in the past two months.
The 10yr nominal or real U.S. Treasury yield vs. the 12mth forward P/E ratio has been watched closely for tactical direction in the equity market — Figure 1 for 10yr real yield using breakeven inflation. The decline in nominal 10yr yields since the June peak has been greater than the decline in inflation expectations, and the decline in real yields has been accompanied by a modest bounce in the 12mth forward P/E ratio and the equity market. What happens from here?
- More Fed tightening and higher 10yr yields. The Fed is clearly considering 50bps or 75bps at the Sept. 21 meeting, and we now look for 25bps in November and December (here). Our reading of employment trends, wage inflation, and core and trimmed inflation measures makes us somewhat more worried about the Fed's ability to get inflation back to target by finishing at 3.25-3.50%. Indeed, we may have to pencil in an additional 25bp hike if the data is resilient in the coming months or if the Fed policy reaction function becomes more hawkish at Jackson Hole or at the September FOMC meeting. Q3 GDP growth will now likely be positive and our technical recession story now only kicks in toward the end of the year. Overall, we are revising up the end-2022 10yr yield forecast to 3.05% from 2.90% in the June Outlook — we had already included a technical recession (here). 10yr yields could, however, go to 3.25-3.50% in the next two months, as Fed policy dominates and not enough cumulative slowdown evidence arrives.
- Marginally higher real yields. 10yr breakeven inflation has crept back up from the 2.29% low on July 6, both as the last U.S. employment report has tempered fears of a recession and as a broader review of inflation indicators suggests less ebbing of inflation than the monthly headline and core CPI for July alone. Breakeven inflation rates will likely not change much in the coming 1-2 months, though all financial markets will remain in a state of flux over Fed policy/economy and inflation. This all suggests that 10yr real yields could push up marginally in the next few months.
- Valuations or earnings estimates. With 12mth forward P/E ratios back in the normal range, valuations may not now give the market major direction. The earnings story has provided support, with Q2 2022 earnings having not prompted a major reset of 2023 earnings forecasts. Indeed, a reset may or may not occur in the Q3 season in October, and a major bottom-up shift requires either a rapid slowdown into recession or perhaps waiting for the effects to feed through to corporate guidance — which could be as late as Q4 season in January 2023. An earnings reset will likely be more important than valuations on a 6-12 month view, which did occur in 2007-8 with multiple derating anticipating an earnings recession. Long-term, the relationship between U.S. 10yr real Treasury yields inverted and 12mth forward P/E ratio has also seen divergence, e.g., 1999-03 and 2011-13 (Figure 2).
Figure 2: Long-term 10yr U.S. Real Treasury Yield Inverted and Forward S&P500 P/E Ratio (% rhs)
Source: Datastream, Continuum Economics using breakeven inflation from index linked bonds
- Real sector deterioration and valuations or earnings estimates? If our economic view is correct, then the period up until the end of the year should see a further deterioration including in employment growth/vacancies that should reduce wage inflation alongside dampening consumption growth. With the U.S. housing sector acting as a drag and the U.S. export outlook deteriorating with Europe's earlier swing toward recession, this should start to see our view of a technical recession coming through in the data from Q4. This may not be fully evident until later in Q4, meaning that the earnings reset now occurs later than we previously thought. We are now less certain that the earnings reset will be priced in before year-end. Thus we are revising up our end-year forecast to 3,750 for the S&P500 from 3,650. This is not to say we are not bearish, and we do feel that the S&P500 could see 3,500-3,600 as a technical recession and flat to small negative 2023 earnings growth are discounted. We have also delayed the Fed pivot into H2 2023, and this means that adverse forces could still be at play in Q1, though we maintain our forecast of a recovery to 4,300 by end-2023.