Are US Equity Investors Too Sanguine About US Economic Prospects?
Yes, it is likely that the “softish landing” implied by forward consensus earnings expectations will fail to transpire. In contrast, we anticipate a recession, given the decline in leading economic indicators and our view that the Federal Reserve will not be quick to cut rates to support activity. After adjusting downward in recent weeks, consensus expectations are within the realm of reason; however, US equity valuations remain elevated and more vulnerable to decline in a worse-than-expected economic outcome. We expect tilting portfolios to value equities will mitigate this risk.
While US equities returned -18% in 2022, the decline was due to valuation compression as interest rates rose sharply. We have argued that if a recession were to transpire, earnings expectations would fall. S&P 500 Index earnings expectations have softened in recent weeks, but they remain optimistic relative to history. The consensus now expects a peak-to-trough earnings contraction of 5.1% between fourth quarter 2022 and second quarter 2023—more realistic, but still well below declines associated with most historical recessions. Indeed, over the last four cycles for which we have data, recession-related operating earnings declines have ranged from -14.6% to -56.5%. Reported earnings date back further and indicate two of the three recessions during 1970–82 saw more mild earnings declines of -4% and -7% in nominal terms, although contracting more significantly after inflation.
Businesses have been able to protect margins to some degree by passing cost increases on to consumers; however, operating profit margins have contracted by 1.3 percentage points from their fourth quarter 2021 peak, with mega-cap tech stocks experiencing the biggest hit. Consensus expectations are for margins to decline to still-high pre-pandemic levels by the end of the year. As such, equities remain vulnerable to downward earnings revisions. To some degree, the impact of lower growth expectations could be offset by lower rates, but unless the recession proves more severe than we anticipate, we expect this counterweight will be limited.
A slew of economic data supports the view that a recession is forthcoming. Leading economic indicators have softened. Most importantly, the ISM Services New Orders Index deteriorated meaningfully in the December reading. Further evidence includes contraction in home prices and tentative signs that the labor market is starting to weaken. Non-farm payroll growth is moderating, average weekly hours worked and temporary help service payrolls are falling, and small business owners are dialing back plans to hire.
The evidence thus far suggests the recession will not be severe. Most importantly, households still have an estimated $1.4 trillion in excess pandemic savings and maintain an aggregate of $5 trillion of assets sitting in cash and available to support spending. At about 3% of household assets, cash allocations are three times pre-pandemic levels. The labor market provides further consumption support. Given the still-high labor demand relative to supply of workers, companies may retain workers more so than in the past, leading to a more resilient economy.
The downside risk to US economic growth ties to the speed and magnitude of Fed hiking, which has been the sharpest pace since the early 1980s. The slowdown may accelerate in the months ahead as much of the impact of aggressive monetary policy tightening may be forthcoming. Although home prices have been hit by higher mortgage rates, the mortgage market is predominately fixed rate, housing supply is tight relative to demand, and mortgage rates have eased from recent peaks. Other possible detractors are a resurgence in commodity prices due to further disruption in Ukraine, higher-than-expected demand from China’s reopening, or geopolitical developments.
In short, recent downgrades in earnings expectations limit downside risk for equity investors, but we believe further revisions will be forthcoming, even if the recession is mild. Still-high valuations pose some risk, but markets can change very quickly making turning points hard to time. Investors are best served by leaning into value and sticking near equity policy allocations.