Stocks rose again on Friday for the third straight session. Futures point to further gains this morning. Since mid-May the S&P 500 has traded within roughly 300 points on either side of 4000. Will the next breakout be up or down out of that range? That’s the question that is uppermost in investors’ minds.
Let’s start with the downside risk. Earnings estimates for next year still are close to $250 for the S&P 500 despite economic slowness so far this year, a rising dollar which hurt the translation of overseas earnings, and continuing supply shortages. Then why haven’t earnings come up short? The answer relates to the inflationary pressures the Fed is fighting. When the Fed looks at growth, it focuses on real growth, adjusted for inflation. But we live in a nominal world. If Company X reports a 7% increase in revenues, how much comes from volume and how much comes from price will vary company to company. Investors, obviously, want to focus more on real growth in volume, but earnings reports don’t differentiate. Thus, while earnings have held up, the quality of earnings have deteriorated as volume increases haven’t kept up with increases in dollar terms.
With inflation starting to recede, earnings expectations may still decline. Using junk bond yields as a proxy for the proper multiple of stocks, the market’s expected multiple of about 17 times next year’s forecast suggests that the Street is discounting earnings of $220-230 for next year, roughly equal to 2022 expectations. Barring a harsh recession, that seems logical.
Thus, for markets to break down through the June lows, one of the following is necessary:
1. Growth rates over the next 12-18 months have to fall well below current forecasts. Remember, this is an economic downturn the Fed created. It was late to tighten policy. If it stays tight too long, it could trigger a downturn larger and longer than needed to fight inflation.
2. A geopolitical tail risk could surface. This would have to be one that has major economic impact. A change in the likely outcome of war in Ukraine could be a possible tail risk, but only if it has significant economic impact. Oil tail risks to watch are the impact of Covid-19 in China, the depth of an emerging European recession, particularly if winter is cold, or efforts by China to unite the mainland and Taiwan.
3. Markets incorrectly discount the Fed’s resolve. Said differently, the Fed could decide to raise short-term rates well past 4.0%. Another possibility is that efforts to reduce its balance sheet creates a liquidity crisis that disrupts financial markets.
Now that we have the downside risks out of the way, let’s look at the upside:
1. The Fed actually hits its soft-landing target and there is no recession. In that case, $250 earnings for next year holds and growth accelerates into 2024.
2. None of the tail risks alluded to above happen.
3. Inflation declines steadily and at a faster pace than the Fed anticipates.
Let me now move to a few observations. The Fed currently is talking tough. Clearly it has decided to raise interest rates past neutral quicker than was anticipated just a few months ago. The impact of that speedier rise has yet to be felt in any significant way. There is a lag between policy implementation and economic impact. Thus, the Fed doesn’t know, nor do we know, how the change to a more rapid pace of rate increases will impact the economy. We see a slowing today, that much is obvious. But the risk of too much restraint does run the risk of crushing an economy that doesn’t need to be crushed to meet the goals of lower inflation.
The Fed now hints that once rates get to 4% or so, they will stay there probably through all of 2023. Don’t take that seriously. The Fed has succeeded in its efforts to cool the economy to date as much by jawboning as by anything else. The reality is that the Fed in the recent past hasn’t been very accurate in forecasting the next six months, much less the next 12-18 months. The reality is that once the Fed gets the Fed Funds rate to 4%, it has no idea what follow-on steps it will take. It will become reactive, not proactive. IF (note the capitalization of the word if) by next Spring the economy is losing 100,000-200,000 jobs each month, recession is upon us, and core inflation is near 3%, there is no way the Fed is going to keep full pressure on its monetary brakes. The Fed has two mandates, not one. Full employment growth is a mandate, as is price stability. Today, it can rightfully say inflation is its biggest concern. It can say that because full employment is not a current concern and the economy is still growing.
The Fed has said clearly that it won’t change policy simply because the stock market is falling. True on the surface. The decline earlier this year was based on assumptions that recession risks were rising and inflation was stubbornly high. What has changed is the rather rapid decline in inflationary pressures. Commodities have largely reversed course. Housing prices appear to have peaked. The pace of rent increases may have peaked as well. Companies are losing pricing power. Wages are still rising but upside pressure is slowly coming down. How much of this is due to Fed action, how much is due to supply chains healing, or how much relates to buyer resistance doesn’t matter. What matters is that pressure is receding. As long as the trend continues, equity investors will gain more confidence.
Will there be a recession? Economists say the odds are rising. As a market observer, I don’t care as much as you might think. Whether the economy grows 1% or falls 1% isn’t crucial. The focus should be on earnings. Good companies and non-cyclical companies should be able to manage through a soft landing or a mild recession without too much long-term damage. Yes, there could be a quarter or two of relative disappointment, but that won’t change long-term values significantly. If stocks look 6-9 months ahead, the question isn’t “what is the outlook for mid-2023”? Rather it should be “in mid-2023, will the outlook be more or less favorable than it is today”? If one sees policy and geopolitical events forcing an extended downturn that won’t allow healing until sometime in 2024 or later, then a bearish stance today is appropriate. If, however, one believes that later in 2023 the Fed will have gotten inflation back below 3% and begins to reduce monetary restraint, then it would be proper to expect the June bottoms to hold.
If I sound a bit optimistic this morning, it is simply because I believe we are closer to the inflection point where the Fed’s restraint is at a maximum. But let me emphasize that once inflation gets contained all isn’t rosy. Worldwide, birth rates are down. Europe is going to face much more difficult economic times ahead than we are. China’s zero tolerance regarding Covid-19 isn’t working. The disease is simply too insidious to be defeated as the Chinese are trying. Instead, these floating lockdowns are hurting its growth at a time when population trends are turning distressingly negative. At the same time population trends are hurting worldwide, the lack of investment has limited productivity gains. Simply said, post-Covid and after inflation is contained, the growth outlook worldwide is much more modest than it has been. There has been a lot of political rhetoric suggesting that sub-2% growth after the Great Recession was due to fiscal policy errors, but the core reason was related to slower demographic trends. These are only going to get worse going forward.
Stocks did very well from 2009-2021. But the above-average performance in stock markets had more to do with multiple expansion than earnings growth. Today, markets sit at a P/E close to historic norms. There should be no expectation that multiples will expand materially from here. In fact, long-term inflationary pressures might mean bond yields stay above the 2009-2021 range for a long time. If so, multiples going forward could decline, not increase. Relief or even a resurgence of euphoria could pull stocks back up to old highs, but enduring bullish performance will depend on earnings acceleration beyond trendline expectations. Right now, that seems a stretch.
Bottom line, the bottom may have been set in June, but I don’t expect a sudden breakout from the May-September trading range anytime soon. Third quarter earnings should be close to expectations. Anecdotal data suggests we are still in a sluggish economy, but not in recession. Companies that do a lot of business overseas are seeing increasing pressure. On the plus side, supply chain disruptions are easing.
In 2008-2009, the bottoming process took six months. The economy was much worse then and required more healing. This time around, listening to the Fed’s stern talk may well lead to the wrong conclusion. The Fed isn’t likely to step on the accelerator anytime soon, but to suggest that it will keep maximum pressure in place until 2024 is probably misplaced. It will keep its foot on the brake well into 2023, but will likely release pressure sooner than present rhetoric from Fed officials suggests.
Today, Jennifer Hudson is 41. Comedian Louis CK turns 55.
James M. Meyer, CFA 610-260-2220