The coming profit squeeze will create opportunities.
View: We remain defensively positioned. Despite the sharp drawdown in equity indices, the valuation of equities relative to bonds has not improved. Central banks’ determination to combat inflation and re-establish their credibility is likely to result in a recession. Earnings expectations for 2023 could be 20-30% too high, unless recession can be avoided.
The 20.2% fall in MSCI ACWI (US$)1 from peak on 16 November 2021 has been entirely driven by valuation multiple compression: company profits have continued to rise but investors are increasingly unconvinced that this is sustainable given rising interest rates.
This bear market, the 20th in the past 140 years, is the result of a rising cost of capital and anticipation of a global recession that appears necessary to bring excess demand into balance with the limited supply of goods, commodities and labour. Equity investors face a period of falling earnings estimates as expectations adjust to the new reality. There will be bear market rallies along the way, but a Goldman Sachs study of S&P 500 drawdowns since 1950 suggests that markets will only begin a sustained recovery when either the US Federal Reserve (Fed) reverses course or global economic activity accelerates.
Oil pumps wage inflation
The inflation spike in the US and Europe stems from the pandemic, when demand boomed due to emergency monetary policies and fiscal relief. Excess consumer savings have sustained upward pressure on prices, together with damaged supply chains, structural changes in labour markets, China’s zero-COVID policy and the invasion of Ukraine. Deutsche Bank estimates that median global year-on-year inflation is 7.9%, up from 3% in June 2021.
Global inflation is heavily affected by oil prices. Sanctions on Russia have removed approximately 1.5% of global oil production, and low investment in the energy industry and geopolitical cross-currents have limited the ability of OPEC+ and international oil companies to make up the shortfall. The Ukraine war is likely to grind on and we may see further oil price spikes as more Russian supply is removed. Ultimately, the cure for high oil prices is high oil prices. Further rises from current levels will make for a more rapid global economic slowdown as demand destruction bites and central banks fight harder against inflation.
More concerning is the inflationary pressure from housing and wages, which could trigger a spiral of rising wage expectations. A recent University of Michigan consumer sentiment survey shows 5-to-10-year inflation expectations rising above 3%, the highest level since 2008 and marginally below levels seen in the early 1990s.
Catch me if you can
The Fed is yet to catch up with inflation. To do so, it must address the imbalance between high job vacancies and low unemployment by using interest rates to reduce demand for labour and encourage people back into the workforce. Given the enormity of the task ahead, this rate hiking cycle is set to be the most aggressive in decades, with rate futures anticipating 250bps of further hikes by February 2023, on top of the 150bps increases from the March, May and June Federal Open Market Committee (FOMC) meetings. Monetary policy can have an immediate impact on market financial conditions via expectations and asset prices, which ultimately slows demand and drags on consumer and business sentiment. However, economic momentum in the US is still firm because consumer balance sheets were strengthened during the pandemic, and it is unclear what level of interest rates are needed to bring the economy back into balance or how long this could take. Interest rate volatility could be sustained and the risk of policy error is high.
Outside of the US, investment conditions are worsening and the risks are considerable. The European Central Bank (ECB) is moving to raise interest rates to combat inflation, raising concerns of euro zone fragmentation at a time of war. In China, an essential engine of global growth, economic and social policies are creating considerable uncertainty, and recent weakening of the renminbi against the US dollar may presage market volatility. Foreign exchange stress is also evident in the yen, which is at a 24-year low versus the US dollar, and many other countries are also struggling to fight inflation while managing currency pressures.
So far, the downside risks of quantitative tightening (QT) have attracted much less attention than interest rate expectations because there is no precedent for a monetary experiment on this scale. At its simplest, QT will detract from money and credit growth; a slowing economy may see less demand for credit and a tightening of bank lending standards that creates a tightening credit cycle for the housing market, consumers and corporates.
Gauging the downside
Evidence of an impending recession is mounting, and even central bankers now acknowledge the risk is rising rapidly. The Conference Board CEO confidence measure for Q2 declined sharply, making a close fit with forward earnings expectations, and there are now more downgrades than upgrades. By Q4 2022 it is likely that the 10-year minus 3-month Treasury yield spread will invert, signalling a high probability of recession within the following nine months. In the meantime, we can expect to see forward-looking indicators such as the closely watched ISM Manufacturing purchasing managers index move below 50, indicating a contraction.
Q2 earnings revisions have been mild so far, but I expect cautious guidance from company management in all regions as they warn of weaker order trends and rising costs. The current strength of the US economy means that negative revisions will be modest initially but likely to accelerate in the second half of this year.
The impact of the coming recession will fall primarily on 2023 profits
Market-wide expectations for 2023 are still relatively optimistic at 10% growth with c40bp of margin expansion. During the last four recessions, the typical revision to consensus EPS estimates during the six months prior to the start of a recession has ranged from -6% to -18%, with a median of -10%. During the six months following the start of the recession, analysts reduced profit estimates by an additional 13%. The median fall in earnings during a recession is 21%, implying significant scope for disappointment.
Since WW2 the median S&P 500 return during periods of recession has been -24%, with the typical peak-to-trough price fall taking 13 months to play out and the range of recessionary returns varying from -14% to -57%. This implies a wide range of potential outcomes.
We are still in the early stages of the adjustment process, when market-wide earnings revisions have barely begun. However, establishing the index level at which a recession has been fully discounted by the market could be done by observing the typical earnings decline during a recession and applying historic recessionary multiples. Unfortunately, the current forward PE multiple of the MSCI ACWI is 14.8x, below the long-run average of 15.4x, but above the 13.3 observed in a recession. Should MSCI ACWI earnings decline by 20% for 2023, this would imply further downside to markets.
The fair multiple for equities should be compared with alternative investments, such as 10-year government bonds. The earnings yield of MSCI ACWI is c6.75% and for the S&P500 it is 6.1%. The equity risk premium (ERP) for the S&P 500 is therefore 2.7% (earnings yield less 10-year bond yield of 3.4%). On this methodology the US equity market is actually more expensive than it was at the end of 2021. Judging the ‘correct’ ERP is challenging, but at current levels the US is relatively more expensive than its long-run average ahead of cuts to earnings forecasts.
Equity markets face a tough six months unless inflation moderates rapidly and prompts a reassessment of central bank policy that reduces the risk of a sharp decline in profit expectations. Investor sentiment is extremely depressed and a positive surprise on inflation would undoubtedly prompt a rally in equity prices, even if this cannot be sustained until profit expectations trough.
No pain, no capital gain
For long-term investors this period of adjustment will offer opportunities: lower share prices and rebased expectations improve the outlook for future returns, and intra-market dispersion provides alpha opportunities.
While our thematic approach identifies long-term investment opportunities that transcend the economic cycle, almost all companies have some cyclical attributes. The dramatic declines in the valuation of US technology stocks is bringing closer the opportunity to increase exposure in areas where we have been lightly invested for some time. Consumer stocks have also suffered as discretionary income has shrunk, although it may be too early to seize this opportunity just yet. Despite the long-term trend away from physical to online shopping, e-commerce stocks have been particularly hard hit as high expectations set by bumper pandemic trading led to disappointment, bringing valuations of the market-leading e-commerce companies back to more enticing levels.
Looking longer-term, our conviction remains undiminished. The challenges of tackling climate change, improving energy security and access to water will require trillions of dollars of investment annually over the next 20 years. Some solutions already exist in renewables, battery storage and green hydrogen, and others will be developed. Although equity markets face a problematic short-term outlook, the march of human progress will continue.
Long-term rates will dictate recovery
With inflation alarmingly high and economic momentum waning, some fear a return to 1970s-style stagflation, but it is not clear that current inflation expectations are unhinged or that wage push inflation is inevitable. Central banks are certainly six months late, but they have the benefit of Fed Chair Paul Volcker’s experience of the 1970s and the remedy.
We can be certain that the recovery in equity markets will be heavily influenced by long-term interest rates. If they return to 2-2.5% and an equity risk premium of 300-400bp is demanded by investors, the global equity market can return to multiples in the range of 15-20x earnings. This bear market is a necessary cyclical adjustment that is likely to inflict limited damage on consumers and corporate balance sheets. Investment opportunities in the recovery phase will be plentiful.
1 Source: Bloomberg and MSCI, 04/07/2022
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