Thus far in 2023, equity markets have rallied strongly with good news celebrated and potential areas of concern dismissed. The trajectory of equity markets over the next 6-12 months will be driven by a) outlook for corporate earnings and potential for recession and b) trajectory of inflation and interest rates.
The case for a soft-landing or Goldilocks like pause in growth with falling inflation has increased. Inflation has clearly slowed in most major regions, and core inflation is falling significantly in the US (when shelter costs are excluded). It is widely expected that the Fed is close to ending its rate hike campaign. However, it is unclear how quickly the Fed will begin to cut rates.
Thus far, continued strong US consumer spending has defied economists’ projections. Consumers still appear to have $500 billion in excess pandemic savings and are willing to take on increasing levels of debt (bolstered by strong employment prospects). US unemployment remains exceedingly low at 3.6%.
Equity markets may continue to appreciate in a scenario where unemployment remains low and inflation continues to fall.
However, investors appear complacent regarding several risk factors.
Manufacturing PMIs in the US and Europe have been in contractionary territory for several months and survey data is worsening. Historically, weakening manufacturing new order survey data has presaged recessions and earnings have subsequently declined 10%-20% from peak levels.
The US Treasury yield curve (10-year vs. 3 months) has been inverted for the past eight months. This yield curve inversion has preceded every recession over the past 50 years, with an average time from inversion to recession of 11 months (not every yield curve inversion has resulted in recession).
Rising interest rates have led to tightening underwriting standards across loan types and less willingness to make consumer and commercial loans. Consumer loan demand remains strong while commercial and industrial loan demand has fallen. Historically, when credit creation and money supply growth has slowed significantly, recession has followed.
Retail investor sentiment indexes have reached highly bullish levels. Presently, investors are the most bullish since April 2021. In many cases, these sentiment indexes serve as contrarian indicators.
As such, this highly bullish sentiment may foreshadow future equity market declines over the next 6-12 months.
We see multiple potential paths for equity returns over the next 6-12 months (with reference to the S&P 500 which stands at 4,505 of July 14, 2023).
Scenario A: (Optimistic Case) – Inflation continues to moderate faster than expected with a soft landing. Fed pauses rate hikes by July and cuts rates beginning in 2024.
Under this scenario, S&P earnings could expand to $240 in 2024 and $260 for 2025 (vs. $218 in 2023). If inflation declines and the Fed cuts rates beginning in 2024, equity multiples may remain at high-teens levels. The S&P 500 index could appreciate from circa 4,500 levels today to 4,800 to 5,100 within 12 months.
Equity markets have already reached the high-end of our previous optimistic scenario (4,200-4,500 YE 2023 target)
Scenario B: (Base Case) – Mild recession emerges in 2024. Fed hikes once more in July but maintains high rates well into 2024.
Under this scenario, The Fed hikes once more in July followed by a pause in rates for 9-12 months followed by rate cuts. The US economy enters a mild recession with 2024 S&P 500 corporate earnings flat to down 7% followed by a strong recovery to $235 to 250 in 2025.
In this scenario, the market may decline to 3,900-4,300 over the next 6-12 months.
Scenario C: (Pessimistic Case) – Core inflation reaccelerates or remains higher for longer leading to more than one Fed hike. Consumers exhaust remaining excess savings and layoffs intensify. European weakness may exacerbate the swiftness of a global recession. This scenario leads to faster and deeper equity market declines followed by a sharp rebound once Fed policy pivots.
Under this scenario, S&P 500 earnings may decline 10%-15% in 2024 with equity markets declining by 15%-20% from current levels over the next 6-12 months. However, such events also increase the chance for an ultimate swift Fed pivot with declining interest rates which would ultimately lead to sharp equity rallies.
At this stage, outcomes remain highly uncertain and may be influenced by several external variables that are difficult to predict.
Given the sharp increase in equity valuations YTD coupled with significant remaining macroeconomic risk factors, we would recommend that investors do not add substantially to equities until there is a 10%+ equity market pullback.
