Economic and Market Review: Key Considerations For Equity Investors
Are we there yet?
After rising interest rates, persistent inflation and geopolitical turmoil pounded equity investors in 2022, we wish we could report that a rebound appears just around the bend. Alas, we believe macroeconomic indicators offer little to cheer about in the first quarter of 2023—and perhaps through the remainder of the year.
Despite Wall Street’s rosier prognostications, we think that a challenging mix of alarming economic inequality, monetary policy headwinds and poor earnings quality will put increasing pressure on corporate profits and likely lead to even lower equity returns in the near term. We anticipate the bear market to continue in 2023 and believe the S&P 500 Index could trough around 3000. (For additional context, see our 3Q 2022 and 4Q 2022 Equity Outlook reports.)
In this paper, we will discuss the U.S. economy’s increasingly Dickensian divide; its implications for the Federal Reserve’s ongoing war on inflation; and what current conditions could portend for equity portfolios over the next quarter and beyond.
—Raheel Siddiqui, Senior Research Analyst, Global Equity Research
We enter 2023 amidst a tale of two economies: As one side enjoys inordinate wealth, the other faces dwindling real incomes. While the economic realities of upper- and lower-tier consumers have always been very different, never has the polarization been this stark—and potentially problematic for the growth of a vibrant and resilient economy.
According to the Bureau of Labor Statistics, the wealthiest 20% of households—which can draw on savings to finance their lifestyles—account for 38% of all spending; the bottom half—with little wealth to lean on—mainly depend on modest incomes to support their spending. To put things in more tangible terms: For every $1,000 in the checking accounts of the top 20%, the bottom 20% currently have just $9; and for every $10,000 of net worth in the top 20%, the bottom 20% have $500, based on data from the Federal Reserve.
The table below offers a snapshot of how rapidly the gap between the two Americas has widened in just 10 quarters.
Dig deeper, though, and the divide becomes a canyon.
Poorer consumers’ credit card and personal loan balances have reached record levels—the subprime category now makes up 20% of all card originations—and delinquencies on auto loans and small-business leases are gathering pace. Americans are once again tapping home equity lines of credit to pay down debt. And it isn’t just the bottom 20% feeling the squeeze: The latest Household Pulse survey shows that 70% of US households face difficulty paying expenses—not surprising given that, for more than half of U.S. workers, wages haven’t kept up with inflation.
Meanwhile, in the same America, demand for expensive Champagne, Lamborghini roadsters, luxury fragrances, Birkin handbags and Swiss watches is white-hot. High-end art is being scooped up; Cartier is opening 10 more stores across the country; plastic surgeons are slammed with elective procedures; and U.S. corporate profits are at a record high.
We believe this exuberance stems in part from the extraordinary wealth effect created by overzealous monetary and fiscal policies in response to the COVID-19 crisis. Since the pandemic first struck, aggregate U.S. household net worth has increased by $25 trillion—a whopping $13 trillion above the long-term trend—including roughly $1.4 trillion in spendable excess savings. Energized by the financial windfall, consumers have been gobbling an array of goods and services at elevated prices without feeling the need to cut back in other areas—all of which has triggered painful, broad-based inflation.
At this pace, the bottom 25% of U.S. households could be in danger of burning through their excess savings by the second quarter of 2023, while the top 25% appear able to keep gobbling until the first quarter of 2024 (see chart). That could keep inflation high for another year or more and further punish poorer consumers with diminishing ability to finance their spending.
Persistent inflation is a truly insidious problem that, in our view, can have broad and harmful economic implications. When income growth trails inflation, the majority of Americans who depend on their after-tax personal income to maintain spending tend to steadily lose financial ground. Alarmingly, growth in real disposable personal income (RDPI) has fallen to negative 2.5%—the lowest level in the six decades before the COVID crisis and far from its historical average of positive 3.2% (see chart).
We believe an economy’s ability to increase RDPI ultimately fosters social and political stability. For a start, falling real incomes threaten a crucial incentive to work. (After all, why would people put in the effort only to get effectively poorer month after month?) Negative RDPI growth also incentivizes illicit behavior: Inflation above 4% has been strongly correlated with rising crime rates over the past six decades (see chart).
In short, high levels of inflation hurt everyone, and sustainable real incomes make the economy viable. Little surprise, perhaps, that RDPI growth has remained positive 95% of the time over the previous 60 years.
Clearly, letting the excess savings drain out is not a defensible inflation-fighting strategy. That’s why we believe the Fed must—and likely will—keep monetary reins tight, as suggested by its uniformly hawkish stance at the mid-December FOMC meeting: Of the 19 economists who weighed in, “no participants anticipated that it would be appropriate to begin reducing the federal funds rate target in 2023.” We believe sustaining higher rates should eventually put downward pressure on asset prices and dissuade the wealthy from continuing to spend at their current pace. (For a deeper discussion on the Fed's continued resolve to fight inflation, see our 4Q 2022 Equity Market Outlook.)
Winning the war on inflation, in our view, means achieving three objectives:
- Turning RDPI growth sustainably closer to its 3% historical average, which signifies a healthy economy
- Neutralizing the wealth effect, mainly by bringing down equity and home prices
- Restoring labor-market equilibrium by generating sufficient job losses to break the wage-price spiral that keeps inflation expectations aloft
Until these three objectives are convincingly met, we do not expect the Fed to loosen the reins. Given where inflation is now and appears to be headed, victory—in our view—likely also requires a moderate recession.
In the current environment, we believe the Atlanta Fed's Sticky-Price CPI offers the truest take on the impact of the Fed's monetary policy on inflation. (“Sticky” refers to prices for essential goods and services—from rent to healthcare—that don’t change as quickly as prices for other items.) While sticky inflation is known to lag aggregate economic activity, inverting this metric can create an insightful leading indicator. As shown in the chart below, cycles in Sticky CPI inflation (inverted) lead cycles in economic activity by six months. The relationship is particularly strong when Sticky CPI inflation is above 3%, which is the case today.
Many on Wall Street think headline inflation peaked in June 2022; meanwhile, in December, the Sticky CPI recently posted its highest year-over-year reading in 40 years and has deviated north of its historical trend by more than we’ve seen since the early 1980s. Sticky inflation also tends to lag employment trends, implying that Sticky CPI tends to peak only after the labor market has visibly weakened. We believe this environment—along with the Fed’s continued commitment to tight monetary policy—bodes poorly for economic growth in the foreseeable future.
If the first swipe of the bear claw slashed valuations, the next, we believe, could gut earnings. While many companies were able to pass along rising input prices and post record third-quarter profits in 2022, we expect a softening in corporate earnings to prolong the bear market until at least late 2023.
The reasoning is based upon our outlook and some of the key themes we envision emerging in 2023:
The recession will be more severe than expected. Many market watchers anticipate the gentlest recession in post-war America, with a peak-to-trough decline in real GDP of 0.2% and an increase in unemployment of 1.3%. We find this view unrealistic in light of the Fed’s extraordinary tightening campaign and impending financial distress for 70% of Americans. Our historical analysis suggests that, in disinflationary recessions, GDP typically contracts by 3%, and the unemployment rate rises by 4%. We believe a deeper recession would deal a bigger blow to corporate earnings than Wall Street appears to expect.
Poor earnings quality will lead to larger write-offs. Aggressive accounting is back in fashion. The use of accounting accruals—which essentially represent best-case financial assumptions that may never come to pass and can lead to glaring disconnects between reported net income and actual cash flow—is the highest we’ve seen in three decades. In economic downturns, such poor earnings quality can quickly translate into write-offs and hammer equity returns. Last year we found accrual-heavy, relatively overvalued stocks declined three to four times more than the overall market. During this next earnings-driven phase of the bear market, we expect companies with the poorest earnings quality could suffer similar fates.
Consider the following two charts. Historically, the annual performance spread between stocks with aggressive and conservative accounting tends to be around 6%. We envision that gap widening—for both value and growth stocks—during the anticipated recession. Indeed, the cracks have already begun to show: As the chart on the left shows, during the 2022 third-quarter earnings season, companies that missed both revenue and earnings estimates immediately shed 6.7% in value—three times the average over the previous 20 years.
We believe the potential flight from poor earnings quality is already apparent at the sector level as well. As shown in the chart on the right, sectors with more aggressive accounting (measured by the number of standard deviations in the size of their accruals) have been hit the hardest, while those with relatively conservative accounting have suffered less. In our view, poor earnings quality has clearly begun to attract investor scorn.
Current earnings are above the long-term trend—but perhaps not for long. Since the 1930s, the collective earnings per share (EPS) for the S&P 500 has hugged a trend growth rate of 6.5%, which now implies a forward, 12-month EPS of $207. Meanwhile, the current top-down consensus for trough EPS is $208, and the bottom-up estimate is 11% higher, at $230 (see chart). We believe both figures are too rosy given that consensus EPS tends to fall 10% to 15% below trend during recessions, implying a trough EPS of about $176 to $186. At a recent 3800, we believe the S&P 500 remains expensive—and thus maintain our trough estimate of sub-3000 (see Appendix for our market views, including our base case for a disinflationary recession).
Optimists crowed when the NASDAQ index jumped 7.4% on November 10. However, bear market rallies are often fleeting: Since 1971, the NASDAQ has staged daily gains of at least 5% on 49 other occasions—with 41 occurring in bear markets.
Gloom-piercing rallies aside, macro indicators offer plenty of doubt about the trajectory of the economy and, with it, our outlook for stocks:
- The US Leading Economic Index is now down for nine consecutive months, and its global counterpart has been down nearly twice as long.
- The US Current Activity Indicator, a broad gauge of ongoing US economic activity, is deep in negative territory.
- Earnings downgrades have been outpacing upgrades, a historically bearish sign.
- Global monetary conditions do not appear to support risk-taking over the next 12 months. Specifically, the global money supply in excess of what the economy can organically absorb is flat—effectively robbing the market of the fuel it needs to spark the next bull run.
Though these observations are consistent with an economy locked in a downcycle and headed toward a recession, the stock market is barely pricing any economic pessimism, as estimated by our valuation-dispersion gauge, based on data back to 1926. This gauge aims to capture the level of economic stress by measuring the gap between the cheapest stocks versus the median performer; the wider the gap, in our view, the greater the potential for generating excess return from value-based stock selection. At present, our valuation gauge is squarely neutral, indicating little stress internalized by the market.
So what does all of this mean for equity portfolios?
- On the simmering question of growth versus value: Both styles currently have very similar betas and we envision them performing quite similarly during the course of the bear market. It is perhaps more illuminating to consider the beta of both growth and value portfolios: We believe a lower-beta value strategy is more likely to outperform both growth and value benchmarks; likewise, we think a lower-beta growth strategy is more likely to outperform both growth and value benchmarks. Across the board, in our view, lower beta likely wins.
- Overall, we see no reason to change the views we’ve offered since the beginning of 2022—that is, we favor lowering portfolio betas across investment styles (small caps, large caps, value, growth, domestic and international) and resist the urge to chase bear-market rallies.
De-risking served investors well in 2022. For example, the USMV—a diversified low-beta US ETF—outperformed the S&P 500 by 868 bps, while its global counterpart, ACWV, topped the MSCI ACWI by 522 bps. If the Fed (as we expect) stays committed to vanquishing inflation—and ultimately shrinking the Dickensian divide—we believe equity investors should remain cautious in 2023.
While our outlook is somber, we wish to remind you that all economic downcycles and bear markets end. Indeed, our farthest-looking indicators have begun to hint that, sometime in late 2023, economic and monetary conditions could turn, which would present a more opportune time for investors to more aggressively add risk to their portfolios. Until then, we think patience is the better part of valor.
Based on their relative sensitivity to changes in inflation and financial conditions, and their historical beta to the stock market, we offer the following as our overweight and underweight views.
|Overweight View on:||Underweight View on:||Neutral View on:|
Factors and Styles:
Household & Personal Products
Factors and Styles:
Automobiles & Components