Are equities due a fall? Four charts for Q1 earnings and beyond

Have #stock markets lost touch with economic reality? This year, #equities have seen strong gains, even in the face of #banking stress, rising interest rates and recessionary fears. The MSCI World and S&P 500 are both up 7% year-to-date; the Stoxx Europe 600 and Nasdaq 9% and 13% respectively. The average company in the S&P 500 is now trading at 18 times forward earnings, versus 15 times in mid-October 2022. And while bond #market #volatility has risen sharply, on equity markets it has remained oddly calm (see chart 1). Indeed, at the time of writing, the VIX volatility measure was at lows last seen in November 2021.

All quiet on the equities front

Equity, bond and currency volatility

This seems at odds with investors’ stated beliefs. Pessimism and bearish sentiment dominated the April Bank of America fund managers’ survey, which showed the most underweight equities allocations versus bonds since 2009. Most economists still expect a recession in the next 12 months, according to a mid-April WSJ survey. Yet market gains show some people are still buying stocks – why?

The case for optimism has many facets. Equities tend to do well after a peak in inflation, which in the US is finally retreating. Markets are pricing in rate cuts in the second half of 2023 – the prevailing argument sees a ‘credit crunch’ following banking stress compounding tight Federal Reserve (Fed) policy to bring growth down sharply. Since mid-March, central banks emergency liquidity measures, and particularly an expanding balance sheet at the Fed, have helped grease the wheels of markets.

The corporate world is also looking surprisingly resilient. Many companies have managed to pass on cost increases to consumers to date. Despite having fallen slightly in recent months, profit margins remain high versus history (see chart 2). US corporate profits as a share of GDP look particularly robust – with 2021’s share (the most recent datapoint) the highest since the 1930s (see chart 3). US share buybacks remain at high levels, and in our analysts’ meetings with companies, management teams report a level of confidence on pricing power.

Marginally down

Net profit margins for S&P 500 companies

A decent slice of the pie

US Corporate profits as a share of GDP*

In our view, the future path of growth will likely be the most important factor for equity markets. Markets keep pushing back their estimates of when a US recession might start. While the labour market is cooling, it still looks solid. Households still have a buffer of pandemic-era savings, albeit a rapidly diminishing one. Corporate spending on core capital goods remains resilient, aided by a push to meet net-zero targets. The big US banks – the first to report Q1 earnings – showed little evidence of widespread consumer suffering. Credit and debit card spending is still growing at above-inflation levels. Late payments on credit cards are rising but remain below pre-pandemic averages. 

Yet a number of leading indicators of corporate activity and consumer spending – including US retail sales, measures of manufacturing activity and companies’ new orders – do suggest weakness ahead. Meanwhile, the inflationary fight is far from over – and will require persistence from the Fed. We expect it to raise rates by a further 25 bps in May, and likely again in June, and to keep them on hold in 2023, absent any unforeseen market stress that would require swift and substantial cuts. We thus expect late 2023 and early 2024 to see recessionary episodes in the US, with a commensurate hit to corporate earnings.

In line with a deteriorating growth outlook, equity analysts’ expectations for first quarter (Q1) earnings have already fallen. On aggregate, analysts now expect earnings for S&P 500 companies to fall -6.8% in Q1, versus -0.3% at the start of the year. But they still expect a pronounced recovery in Q4 2023 and 2024 (see chart 4).

Earnings growth expected to turn positive in the second half

S&P 500 earnings per share consensus analyst estimates, % year-on-year

This looks optimistic to us. Our base case sees S&P 500 earnings falling -5% this year, versus consensus estimates of -1%, and the index ending the year around 3,900, around 4% below current levels.

Headline equity market strength hides a more nuanced picture beneath the surface. Recent gains for the S&P 500 have been led by a few mega-cap stocks with big index weightings, notably technology and consumer defensive firms. Meanwhile, credit spreads are widening, particularly those for riskier companies.

In this environment, we are taking a neutral approach to equities. In early April, we implemented put spread strategies on the S&P 500 to partially shield year-to-date gains. Within our equity allocations, we prefer quality and value stocks, and particularly defensive companies with strong pricing power in the healthcare and consumer staples sectors.