Thus far in 2023, equity markets have rallied sharply, especially in the US. 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. 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.
Most economists now estimate a 20%-40% chance that the US experiences a recession over the next 12 months (down from 40%-60% six months ago).
Thus far, continued strong US consumer spending has defied economist projections. Consumers still appear to have $1 trillion 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 3.8%.
Equity markets may continue to appreciate in a scenario where unemployment remains low and inflation continues to fall.
However, several significant risk factors remain.
Geopolitical tension is high with two current armed conflicts in Russia / Ukraine and now the tragic events in the Middle East and with increasingly strained US-China relations.
Should war in the Middle East spread to involve larger parties such as Iran, oil prices would likely increase significantly which in turn could speed up the onset of recessionary conditions.
European macro economic data remains weak with slowing now seen in services PMI surveys as well as in manufacturing surveys. If Europe was to weaken further, this could spill over to the rest of the world.
The US Treasury yield curve (10-year vs. 3 months) has been inverted for almost a year. This yield curve inversion has preceded every recession over the past 50 years, with an average time from inversion to recession of 11 months (but 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. Historically, when credit creation and money supply growth has slowed significantly, recession has followed.
US government shutdown risks have increased given the elevated level of political infighting.
We see multiple potential paths for equity returns over the next 9-12 months (with reference to the S&P 500 which stands at 4,358 as of October 10, 2023).
Scenario A: (Optimistic Case) – Core inflation continues to moderate faster than expected with a soft landing. Fed does not raise rates anymore and begins to trim rates in 2024 as inflation drops toward its 2% target.
Under this scenario, S&P earnings could expand to $250 in 2024 and $270 for 2025 (vs. $218 in 2023). Equity multiples may expand to 19x-20x forward earnings. The S&P 500 index could appreciate to 5,000 to 5,300 by YE 2024 (15%-21% price appreciation).
Scenario B: (Base Case) – Fed holds rates steady until well into 2024 causing a mild recession.
Under this scenario, the US economy enters a mild recession with 2024 S&P 500 corporate earnings down 5% to up 5% followed by a strong recovery in 2025. In this scenario, the market may initially decline by 5% to 10% over the next six to nine months before recovering to close 2024 in the 4,300 to 4,700 range (up 3% at the midpoint from Oct 10, 2023 levels).
Scenario C: (Pessimistic Case) – Core inflation reaccelerates or remains higher for longer leading to additional Fed hikes.
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 an eventual sharp rebound once Fed policy pivots.
Under this scenario, the resultant recession is likely to be deeper. 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 increase in equity valuations YTD coupled with significant remaining macroeconomic risk factors, we would recommend that investors do not add substantially to equities at these levels.
