Morgan Stanley with a good note on where next for stocks. I would only add that there is another scenario that it does not explore that constitutes my base case. It is that in front-loading its hiking cycle, the Fed breaks something relatively quickly and markets effectively end the cycle by overshooting until it relents.
Certainly, this is a known unknown. But it is the norm rather than the exception in the Fed tightening cycles, not least when it is attacking demand to address largely supply-side inflation.
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We’re in the midst of a hotter but shorter cycle in the US. We first made this case in March of last year,arguing that this cycle was likely to progress quicker than the prior four given the velocity of the growth rebound following the Covid recession, the return of inflation after a 40-year absence,and a much earlier-than-expected shift to more hawkish monetary policy.Fast forward to today,and that’s what appears to be happening—earnings have accelerated past prior cycle peaks historically quickly and are now starting to decelerate from a growth rate perspective, inflation is at a multi-decade high,and the Fed has hiked twice just two years into the cycle.
The key implication here is that the early-to-mid-cycle benefits of positive operating leverage are behind us,and earnings growth is likely to decelerate, driven by margin compression and slowing top-line growth. This dynamic is confirmed by output from our leading earnings model and the recent downward pressure we have seen in earnings revisions breadth. Coupled with decelerating PMIs, this downdraft in earnings growth we expect into next year gives us high conviction that our ‘ice’ scenario has arrived and it’s here to stay for even longer than we envisioned going into this year.
Why can our ‘ice’ scenario persist in the context of a hotter but shorter cycle? 1) The Russia/Ukraine conflict has exacerbated inflation pressures particularly for energy and food; these cost pressures continue to weigh on already depressed consumer sentiment. 2)Labor and input cost pressures remain sticky and continue to pose a risk to corporate profit margins.3) Tighter monetary policy is now having an economic impact, particularly within the housing market, where affordability and mortgage costs are affecting households. 4) We’re starting to see signs that excess inventory is building in consumer goods; it’s happened more slowly than we initially anticipated, but that means pricing/discounting risk for impacted companies can linger for several quarters.
We continue to believe that the US equity market is not priced for this slowdown in growth from current levels. In fact, based on our fair value framework, the S&P 500 is still mispriced for the current growth environment. We leverage the strong relationship of PMIs versus equity risk premium over time to project fair value ERP based on the current level of the US ISM Composite PMI. Based on this approach, fair value ERP is 330bp. Applying today’s 10-year yield to our fair value risk premium indicates a forward multiple of ~16x and an S&P 500 price level of 3,700-3,800. Weaving that tactical setup in with our forward 12-month price target of 3,900 implies that we expect to overshoot our target to the downside in the near term before working back toward 3,900 next spring.
On that score, we expect equity volatility to remain elevated over the next 12 months. As we wrote about in our 2022 year ahead outlook, one of the hallmarks of this cycle is likely to be elevated economic and earnings uncertainty. Add in the elevated geopolitical uncertainty thathas arisen over the past several months amid the Russia/Ukraine conflict and the table is set for volatility to persist. We expect elevated performance dispersion in this type of environment and favor companies that can deliver on cash flow and operational efficiency. We stick with our defensive bias given our broadly riskoff view and remain overweighthealth care,utilities,and real estate.
Base Case Price Target for 2Q23: 3,900
In our 3,900 base case, the market puts a 16.5x P/E multiple on forward (June 2024) EPS of $236. We expect the market multiple to de-rate further from current levels over the next 12 months driven by a higher equity risk premium (~325 bps) as earnings,economic, policy and geopolitical uncertainty remain high. While the multiple compression we embed in our base case is fairly modest given the recent drawdown we have experienced in equities, we think the risk is elevated that the market multiple overshoots our base case to the downside in the near term (see Weekly Warm-Up: That Escalated Quickly As News Always Follows Stocks). On the earnings front, we take down our estimates as cost pressures continue to ramp up, top line growth slows and output from our leading earnings model points to a further deceleration in EPS growth. Our earnings estimates are now well below consensus out to 2024. Specifically, we see 8% growth in ’22 (consensus is at 10%),5% growth in ’23(consensus is at 10%) and 0% growth in ’24 (consensus is at 9%). In short, the over-earning that took place post the covid recession is worked off as demand slows and cost pressures eat into margins. In the absence of a recession (our economists’ base case view), this dynamichappens less abruptly at the overall index level, but we continue to believe it may feel like a recession for certain areas of the equity market over the next twelve months (specifically those areas tied to the consumer goods and technology overconsumption that transpired in 2H ’20 and ’21).
Bottom line: ‘fire’ AND ‘ice’ persist as theFed continues to tighten polic yinto a slowing growth environment. Expect decelerating earnings growth, a lower multiple and elevated volatility. An overshoot to the downside of our next twelve month multiple and price targets is likely tactically as the market discounts (in advance) the consolidation in earnings expectations we expect to transpire over the coming months.
Bull Case Price Target for 2Q23: 4,450
In our 4,450 bull case, the market puts a 17.9x P/E multiple on forward (June 2024) EPS of $249. A soft landing is achieved in our bull case. The Fed’s hawkish path is not a risk to the US growth backdrop, consumer confidence rebounds as inflation fades, cost pressures ease along with inflation as supply chains reopen in an orderly manner,= corporates maintain pricing power,and any excess inventory build in consumer goods is absorbed by household demand.
As noted in the Global Strategy Mid-Year Outlook, this scenario could also involve changes to China’s covid policy and a more positive geopolitical situation in Europe. Amid this backdrop, multiples expand to 17.9x,and the equity risk premium remains around post-GFC lows (~280 bps). On the earnings front, growth is modest but still positive out to 2024 as margin pressures are less significant than in our base case. Bottom line:earningsgrowth slows but is still positive, cost pressures ease as inflation is curbed, consumer confidence rebounds, and excess inventory in consume rgoods is absorbed—a soft landing where multiples have room to expand.
Bear Case Price Target for 2Q23: 3,350
In our 3,350 bear case, the market puts a 15.9x P/E multiple on forward (June 2024) EPS of $212. This scenario assumes a recession. We have earnings growth decelerating in 2022 and then outright negative in 2023(-10%) from a calendar year standpoint. We then see 2024 EPS growth rebounding off of recession comps, finishing the year +17%. In this scenario, margin contraction is more severe in 2022and 2023, and nominal top line growth nearly contracts on a year-over-year basis by 2023, only kept modestly positive by inflation. Bottom line: sticky input/labor cost inflation drives sustained margin pressure. Payback in demand is a dominant theme, leading to a broad deceleration in sales growth. That combination takes EPS growth negative in 2023. At the same time, stickier inflation keeps the Fed on a hawkish path despite decelerating growth and tightening financial conditions.
He is also a former gold trader and economic commentator at The Sydney Morning Herald, The Age, the ABC and Business Spectator. He is the co-author of The Great Crash of 2008 with Ross Garnaut and was the editor of the second Garnaut Climate Change Review.
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