U.S. Equities and the Earnings Question
The focus around U.S. equities is switching from derating of earnings multiples to expectations that bottom-up analysts will downgrade 2023 forecasts. When will this occur, and will it mean a bottom for U.S. equities?
Bottom line: We see a bottom for the U.S. equity market around 3,500, as a technical recession is discounted in 2023 corporate earnings but hope then turns to a 2024/25 economic and corporate earnings recovery. The critical uncertainty in timing and magnitude is the monthly core and headline inflation outcomes for the U.S., as this will dictate whether Fed policy expectations can help or hurt the equity market. Persistent elevation of inflation could force the Fed to tighten to 4% (our alternative view), which would deepen the economic and earnings recession. Our baseline view on inflation, in contrast, allows the Fed to slow the pace of tightening and then stop in November, before swinging toward an easing cycle in mid-2023. This can allow a U.S. equity market rebound in 2023, and we look for the S&P500 to 4,300 for end-2023.
Figure 1: S&P500 Earnings Change (%)
Source: IBIS
Earnings the Next to Drop
Bottom-up equity analysts are looking for a 9.7% increase in S&P500 earnings for 2023 (Figure 1), which top-down economists and equity strategists regard as too high given the growing risk of a sharp slowdown in the U.S. economy. With 12mth forward P/E ratios now around recent historical averages, the outlook for U.S. equities is increasingly being seen as a function of earnings revisions. The recent bounce in the S&P500 is being viewed as a short-covering squeeze that is not a proper bottom, given concerns over earnings.
Equity analysts will want to see the Q2 company performance when the earnings season is at its peak mid-July to mid-August, plus the associated guidance for Q3 and Q4. However, companies' deterioration in profitability could take time to come through, and it could be the Q3 earnings season (mid-October to mid-November) that proves more important in shaping 2023 earnings downgrades. This could leave a gap over the next 6 months between bottom-up analysts and top-down strategists. Additionally, divergence exists among top-down strategists on whether the U.S. economy will slow to below trend, see stagnant growth or experience a mild recession — a deeper recession is a fourth alternative but attracts less support.
We look for a technical (mild) recession to start from Q1 2023, which we project will mean zero 2023 corporate earnings growth for the S&P500. Some real sector data is showing the effects of negative real wage growth, the Ukraine war and tightening of financial conditions, but further feedthrough will likely be seen in H2 and the consensus may not come down to zero for 2023 earnings until well into Q4. It is also worth pointing out that the U.S. high-yield spread (Figure 2) has continued to widen during the recent S&P500 bounce and is not yet at the averages normally seen before recessions of around 800bps. This could also provide tactical risks to U.S. equities.
Figure 2: U.S. High Yield Spread vs. Treasuries (%)
Source: Datastream, Continuum Economics
These are the main reasons behind our S&P500 forecast of 3,650 for end-2022 (here) and a bottom probably around 3,500. At 3,500 and using a market consensus of $229 for 2022, this would be 15.3 on a 12mth forward P/E ratio. Though the market bottomed in 1991 and 2009 with 12mth forward P/E ratios below the average, we feel that this is unlikely to be needed this time and around 3,500 should be a bottom. We then project 4,300 for the S&P500 for end-2023, for a number of reasons:
- Technical recession rather than deep prolonged recession. We do not see a prolonged recession for the U.S. Fiscal policy is neutral and likely to remain so after the November mid-term elections. Monetary policy is swinging toward moderately restrictive based on the Fed dots, rather than truly restrictive. Structural strains do not exist for households and the banking sector, unlike in 2007, while the aggregate corporate sector is not overleveraged. Finally, we look for CPI and PCE inflation pressures to ebb, as pent-up demand after the post-COVID reopening ebbs; global supply chain problems continue to ease; and the Fed's tightening slows the economy and curtails second-round inflation feedthrough. If a technical recession is the end result, then the equity market would look forward to economic recovery in 2024/25 and a corporate earnings rebound.
- Fed stops tightening and starts 2023 easing. Our baseline view in the June outlook (here) is that the Fed will end the tightening cycle at 3.00-3.25% in November, as incoming economic data proves to be weaker than the Fed's projections and as monthly core inflation numbers come under better control. In the June FOMC meeting, Fed Chair Jerome Powell emphasized headline inflation, but in policy decisions we feel that the Fed will look at the trajectory of both core and headline. Uncertainty still exists around gasoline prices in the U.S. due to tight refinery capacity and upside risks to crude oil prices, and we recently modeled the shock from a $160 WTI price (here). However, on our baseline macro views, we see monthly headline and core inflation being better controlled in 2023 and moving toward consistency with the Fed inflation target. This in turn will allow the Fed to take out insurance against a deeper recession by undertaking a 25bp cut in June 2023 and a further 50bps of easing in Q3 2023. Some are looking for more aggressive easing like 2019, but the core PCE inflation picture is likely to be just above 2% in Q4 2023 vs. a more benign outlook in 2019. Although our easing cycle view is modest, it would still be an easing cycle for the equity market. This would likely not only stop earnings derating, but also could prompt a rise in the 12mth forward P/E ratio during 2023.
The critical uncertainty in all of this is the monthly core and headline inflation outcomes for the U.S., as this will dictate whether Fed policy expectations can help the equity market. Persistent elevation of inflation could force the Fed to tighten to 4% (our upside view for U.S. Treasury yields in Figure 2), which would deepen the economic and earnings recession. Our baseline view on inflation, in contrast, allows the Fed to slow the pace of tightening and then stop in November, before swinging towards an easing cycle.
Figure 3: Scenario Assumptions for 10yr U.S. Treasuries
Source: Continuum Economics