The 2023 Equity Outlook: Earnings Forecasts Are Counting on Goldilocks

Summary

• Equities are sometimes regarded as an inflation hedge. But during the latter part of the 20^th century, T-Bills were the far better investment.
• The Fed has battled inflation in 2022 with a ‘shock and awe’ campaign of four 75bp rate hikes. Yet versus previous hiking cycles, the Fed remains remarkably dovish.
• Either the Fed still thinks inflation will soon recede or it will be forced to raise rates well beyond 5% in 2023.
• Analysts are pencilling in earnings growth of 9.7% in 2023. This will entail a Goldilocks scenario of falling inflation and steady economic growth – an unlikely scenario in our view.

Market Implications

• We expect equities to trade in the range of the past six months for now, although the robust labour market and upcoming earnings season may provide a tailwind in the coming weeks.
• Equities will exit that range – whether up or down – as it becomes clear whether the Fed has done enough to quell inflation.
• We see risks tilted to the downside and are underweight equities.

Introduction

As we move into the new year, the three biggest issues for equity investors must be earnings, inflation and the likely Fed response. And somewhere in the not-too-distant background is the prospect of a recession. As we show in this note, all are closely linked.

In short, we see equities trading in a range for now, with any sustained rally unlikely. Risks are tilted toward a sharp selloff if earnings weaken or the Fed keeps raising the Federal Funds Rate (FFR) above the current consensus of 5%. Given the relatively robust economy, tight labour market, and mostly good earnings recently, those risks appear more likely to emerge later in the year.

For now, we are underweight equities, although the trading range pattern may present opportunities for trading-oriented investors.

Given ongoing concerns about inflation, we open with a review of equity performance over the past 60 years, before and after inflation. We then compare the Fed’s recent response to inflation with how it responded to previous bouts of inflation. Finally, we discuss the outlook throughout 2023.

Inflation Bites Hard

The story of skyrocketing inflation during the 1970s and subsequent multi-decade effort to control it is well known. Equities enjoy a reputation as an inflation hedge, but the reality is quite different.

The S&P 500’s (SPX) performance over the past 70 years has been extraordinary, even with the selloff of 2022 (Chart 1a). Since 1954, it is up nearly 150-fold, or 7.5% per year. But adjusted for inflation, the SPX barely registers – rising 17-fold or 4.3% annually.[1] In Chart 1b, we convert prices to a log scale to better illustrate the relative growth rate over time. (We use a log scale for most subsequent charts.)

Notably, in real terms, the SPX reached a high in 1965 – then traded underwater for the next 25 years, as indicated by the red line. Real SPX only started to outperform real GDP after the 2008 financial crisis when the Fed cut rates to near zero.

Granted, we are looking at price returns, and the SPX does pay dividends. If all dividends were reinvested, the real total return is about 9.9% annualised, or a 670-fold growth over 70 years. But even on a total return basis, real SPX traded below its 1965 high until late 1982 (Chart 2).

T-Bills Were the Best Inflation Hedge

But more sobering is the relative performance of the SPX total return versus treasury bills (T-Bills). Assume a prescient SPX investor cashed out in 1965 and simply invested in T-Bills. Adjusted for inflation, that strategy would have outperformed the real SPX total return from 1965 to 1992. On a price basis, the real SPX did not pass the T-Bill strategy until 2016.

Real Earnings Stagnate – It gets worse. Over the past 70 years, SPX earnings grew 6.5% per annum but only 3.3% on a real basis. After the 1965 peak, real earnings did not fully recover until late 1993 – when inflation finally fell to about 2%. Real earnings lagged behind real GDP until mid-2021, when the pandemic yielded extraordinary earnings gains at several large tech companies. Real earnings could easily slip below real GDP again in a more serious recession scenario.

The SPX managed to outrun earnings on a price and total return basis, but this was because of the systemic decline in rates and a steady revaluation of future cash flows as the discount rate fell. With the 10-year Treasury rate now near 3.7%, any revaluation from lower rates will be relatively modest.

Our purpose here is to illustrate the corrosive impact of inflation over time on equity returns and earnings. We acknowledge that there have been periods when the SPX and earnings per share (EPS) have far outperformed T-Bills and real GDP. The 1990s is a prime example, as are the years following the financial crisis. But capturing this outperformance would require an investor to be out of equities during bad times and in the market during good times – a difficult feat indeed.

What About Recently?

Over the past year, real EPS has all but flatlined. It is up 2% YoY and down 0.2% since June 2022 (Chart 4). Nominal EPS is up 7.8% and 0.8%, respectively, over the same periods. We note two points:

• Companies are finding it increasingly difficult to pass on rising costs, hence the negative real earnings growth.
• Earnings growth is slowing on both a nominal and real basis.

Inflation is likely contributing to slower earnings growth, but in fairness, there were sharp slowdowns in earnings in 2016 and 2019 when inflation was near 2%. Other factors have been at play in the past year, including changing spending patterns as Covid risks and restrictions recede, and ongoing supply chain problems that hurt sales and earnings (for example, the auto industry).

We suggest that if inflation remains relatively high in the coming quarters or is slow to decline, it will increasingly weigh on corporate earnings and equity performance.

Is the Fed Still Dovish?

The Fed has responded to the 2021-22 burst in inflation with an aggressive series of four 75bp rate hikes to a 4.75-5.00% range (Chart 5). It is widely expected to raise rates again and hold near 5%.

One might reasonably wonder if the Fed is still dovish, given how it has responded to inflation or an overheating economy over the past 70 years. Inflation is higher than it has been since late 1982. Yet the mooted 5% terminal rate is considerably lower than inflation – and in every previous cycle, the Fed raised rates well above inflation.

What is the Fed thinking? We offer several possibilities:

• The Fed remains confident that current inflation is largely caused by various onetime factors that will unwind over time – albeit more slowly than expected a year ago.
• The Fed is desperately trying to engineer a soft-landing scenario, hoping that inflation will somehow decline without further rate hikes or a recession.
• The Fed is still behind the curve and will have to keep raising rates later this year to quell inflation and bring it down to the 2% level.

We do not pretend to know the correct interpretation here. Suffice it to say, few people have consistently had the correct call on inflation over the past year. But clearly, these possible outcomes imply very different outcomes for equities in the months and quarters ahead.

Persistent Inflation – If the Fed stops raising rates near 5%, we anticipate the economy will continue to chug along and employment will remain high for at least the next few months. Ongoing uncertainty about inflation and a possible recession should keep equities trading in the range of the past six months.

If inflation remains persistent, at some point the Fed will have to raise rates further, raising the risk of recession and likely sparking a further selloff in equities.

Goldilocks! – If inflation recedes as onetime factors unwind, this is the Goldilocks scenario. The economy will achieve a soft landing. Employment will remain high, GDP growth will remain solid, and companies should continue to post solid earnings gains. Equities will rally, but it may be muted as long as rates remain near present levels.

Both the FFR and the 10-year Treasury yield were higher than present levels up until 2008 – even with inflation mostly near 2% since the 1990s – without stifling the economy. If the economy can withstand a policy rate near 5%, we anticipate the Fed will be slow to cut rates, preserve a cushion to cut rates to fight a future recession or crisis, and keep as much distance as possible from the lower zero bound.

Earnings Forecasts Are Counting on Goldilocks

As emphasised in the introduction, the 2023 outlook for equities is about earnings, inflation, and the Fed response.

Analysts are now pencilling in earnings growth of 9.7% for 2023. For that to happen, either inflation must remain near present levels (and companies be able to pass on higher costs) or the Goldilocks scenario must unfold.

If the Fed must keep raising rates to lower inflation, earnings growth will be difficult to achieve. Equities will come under pressure from lower earnings expectations and higher rates.

In either scenario, we expect equities to trade in the range of the past six months for now. Markets may enjoy a tailwind in coming weeks given the still-robust labour market, economic growth, upcoming earnings season, and the prospect that the Fed will soon be on hold. But any exit from that range – whether up or down – will depend on some combination of inflation, the economy, and the Fed.

We continue to see risks tilted to the downside. We would take advantage of any rally to reduce equity positions.

[1] We deflate nominal series using the Personal Consumption Expenditures Index (PCE).

Over a 30-year career as a sell side analyst, John covered the structured finance and credit markets before serving as a corporate market strategist. In recent years, he has moved into a global strategist role.

(The commentary contained in the above article does not constitute an offer or a solicitation, or a recommendation to implement or liquidate an investment or to carry out any other transaction. It should not be used as a basis for any investment decision or other decision. Any investment decision should be based on appropriate professional advice specific to your needs.)