April 13, 2023
Equities have had an impressive run so far this year, with the S&P 500 up 6.6% year-to-date and the Nasdaq even higher at 14%. Yet at the same time the bond market has been signaling a recession is ahead, leaving investors wondering if equity markets are too optimistic as first quarter earnings season begins, and if this is another bear market rally.
Whether or not the market can climb the proverbial wall of worry will depend on the direction of S&P 500 earnings estimates for 2023 and 2024. Investors should get more clarity over the next few weeks as first quarter earnings season ramps up.
U.S. stock returns will depend on the economy, the Federal Reserve and fiscal policy more than usual this year. Our base case is a range-bound market in 2023, reflecting downside earnings risk and reasonable valuations, which could be buffered by supportive policies. Given the uncertain macro environment, we have analyzed various earnings paths and implications for U.S. equity returns.
S&P 500 earnings per share (EPS) estimates for 2023 have declined from a peak of $251 in May 2022 (which represented a 10% year-over-year growth rate), to the current estimate of $221 (a 1% year-over-year growth rate).
The table below breaks down the current consensus EPS forecasts for 2023 and 2024, along with three different scenarios for revenue growth and margins. These top-down estimates give a sense of where EPS can go under different assumptions for revenue growth and profit margin expansion.
1. Our base case for an EPS scenario of $205-$215 assumes a 50% chance of a recession, derived from a probability weighting of earnings forecasts in the “no landing” and “hard landing” scenarios.
2. An optimistic “no landing” scenario, where economic activity does not slow, assumes mid-single digit revenue growth with 5-6% nominal GDP growth and flat margins. This would result in a trendline S&P 500 EPS growth of about 7%, to $235.
3. The “hard landing” scenario assumes a prolonged recession with low single digit revenue declines and lower margins. This results in an estimated 11% EPS decline to $195.
As is often the case during periods of economic inflection, we expect incremental margin changes to play an outsized role in determining where earnings end up.
Market consensus currently has operating margins (EBIT, or earnings before interest and taxes) rising to a record high of 17% in 2023 and expanding to 18% in 2024. We believe this will be difficult to achieve, given material and labor costs (the Producer Price Index) are still elevated while pricing power (the Consumer Price Index) is fading. Since costs tend to be stickier than revenues, declining revenue growth alone could cause margin contraction. This means the market could be at risk of an earnings recession even without an economic one.
Monetary policy has operated with an historical lag of 12-24 months on the real economy. If a recession occurs in 2023, then this year’s EPS could be down as much as 10-20% year-over-year from 2022. In this case, the base from which 2024 earnings grow will be lower, although earnings growth re-acceleration in 2024 could be higher given easier comparisons.
If economic activity holds up in 2023 and a recession is delayed until next year, then 2024’s consensus outlook of 12% EPS growth to $248 is probably too high.
Our year-end target of 3,800-4,500 for the S&P 500 reflects the extraordinary uncertainty in the macroeconomic environment that could result in EPS outcomes outside of our base case outlook, ranging from $195 in a hard landing to $235 in a no landing scenario.
The table below provides a range of dynamic outcomes, as the market rarely stays at extremes for any length of time, whether it’s at market cycle tops (high valuations and high EPS) or lows (depressed valuations and low EPS).
We assume a 17-20x average multiple for our base case scenario, outlined in the blue box. The hard landing (red) and no landing (green) scenarios show lower and higher valuation assumptions.
At cyclical troughs, collapsing earnings are normally followed by easier monetary policy and counter-cyclical fiscal measures, such as unemployment benefits and stimulus programs, which support higher valuations as the market looks ahead to an earnings recovery. In the current market, the floor on the S&P 500 P/E appears to be around 15.5x. Should multiples contract to this level, we expect the decline would be temporary and create a potential buying opportunity.
Despite a strong start to the year, we believe U.S. equity returns are likely to be modest for 2023, with a pick-up in volatility over the next few months. Given the lagged effect of tighter monetary policy and the lengthy era of easy money that came before, there will be periods where the market diverges from our 12- to 18-month outlook and is driven by factors such as low market liquidity, investors’ low equity exposure, and extremes in investor sentiment.
In light of increasing volatility in the capital markets, this analysis serves as one of the fundamental anchors to our broader asset allocation outlook. While there can be dispersion in earnings estimates, our asset allocations for investor portfolios reflect expectations for an economic slowdown this year, with markets looking through to recovery in 2024. We continue to believe our neutral exposure to equities is prudent as it allows us to remain invested while providing the flexibility to take advantage of more attractive entry points in a risk-off market environment.
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