Caught between a rock and a hard place

As I write this memo, I am flying back to the U.S. from what has been a surprisingly upbeat (or at least less downbeat than expected) research trip to Germany. Most of the companies we visited are “hanging in there.” Costs are up and wages on the rise, but in most cases upward pricing adjustments and productivity improvements are offsetting them. Volumes remain in modest growth mode and the energy crisis seems manageable: conservation measures and the shutdown of the most energy-inefficient plants have everyone feeling the worst has passed. On the other hand, news channels were packed with stories about the impact of inflation on Europe’s working classes. The latest strikes in the U.K. (by the nurses and the ambulance workers unions) are pushing for double-digit wage increases to offset rising energy and supermarket bills.

Even as I was getting sufficient corporate-level input to begin questioning our downbeat earnings forecast of $200 on the S&P 500, markets in Europe and the U.S. were taking another dive. They were surprised by the harsh tone of the Federal Reserve and European Central Bank on rate hikes to come and, importantly, to stay. We hope readers of this space were less stunned. We’ve been pretty consistent that the Fed is using the inverse of the ’70’s playbook and is not likely to “pivot” anytime soon. 

Which brings us to the ‘rock and a hard place’

Think of the “rock” as the Fed. Given its determined quest to hike until unemployment rises enough to bring wage pressures back in line with something more consistent with 2% inflation, tight monetary conditions are likely to be with us through much of 2023. But with earnings still strong and corporations still trying to clear their Covid order backlogs, hiring remains firm and layoffs scarce in most sectors. So the deflationary pressure the Fed is waiting for should stay distant and monetary conditions tight. Risk premiums and discount rates likely will continue to rise, keeping a lid on stocks.

• Up against a rock: An earnings forecast of $235 at 17x gets you close to our 3,900 upside target for 2023. Sooner or later, the Fed will win. It always does. (For reference, see my still-in-process book, “Forty Years, Forty Lessons,” chapters 1, 6, 12, 17 and 33—“Don't Fight the Fed.”) When it finally does, the economy should start to soften, and our hopes for a better outcome will be dashed against the “hard place:” earnings. By then, volumes should finally begin to fall, with margins coming under pressure. Stocks, valued on earnings, likely will be worth less.

• The hard place: An earnings forecast of $200 at 17x gets you to our 3,400 downside forecast for next year. Our outlook for range-bound markets continues, to the extent the economy and earnings remain resilient, the Fed keeps hiking and stocks can’t reach escape velocity. Once the Fed succeeds in weakening the economy and earnings, conditions should ease—but only after earnings drop. Rocky landings are like this.

The line moves up and to the right

For those discouraged by our lack of near-term optimism, please focus on this other important long-term lesson. We’ll get through this, and the economy and earnings will resume their slow upward path, with the Fed on the sidelines. The Goldilocks scenario is out there, waiting for us to get through this rocky valley.

For now, stay defensive and avoid getting clobbered by flying rocks. A better day is coming, just not yet.