Even rocky landings can have big bounces
Remaining defensive as 2023 consensus on earnings and Fed remains too optimistic.
It’s been over a year since we first began scaling back our then recommended overweight to growth stocks, shifting into more defensive value/dividend paying names and money markets. In the two weeks since the S&P 500 was down 25% year-to-date and the Russell 1000 Growth Index was down 32%, markets have staged a broad and impressive 8% rally. So clients are asking: do I buy in here? Are markets sniffing out positive news flow ahead on earnings, the Fed, China, the election, or something else? We think they may be doing just that or, in market lingo, “the market may be anticipating the turn of the second derivative.” Unfortunately, we think the market is wrong this time around.
Economy showing signs of softness but more pain to come
In the “bad news is good news” category, a number of economic indicators suggest the U.S. economy may be softening enough for the Fed to at least scale back on the pace of its rate-hiking program. Although third-quarter GDP was recently flashed as positive, markets noted that much of the strength came from the fickle net export numbers and that beneath the surface, consumers were struggling to adjust to historically high inflation. The rate-sensitive housing market, measured by home starts, mortgage applications, etc., clearly is sinking. And core inflation readings, such as core PPI and core PCE, have at least stabilized for now, albeit at a too high 5-6% level. Although the jobs market remains tight, anecdotal announcements of hiring freezes and layoffs within the bloated tech sector suggest that softness lies ahead. Unfortunately, we anticipate this softness will continue for an extended period of time, well into next year, as the lagged impact of this year’s Fed hikes begins to bite and the sell-off in growth stocks begins to really impact hiring and layoffs in what seems to have been an historically over-invested tech sector. A true recovery, we think, is still several quarters away, and in fact, we’ve recently cut our economic growth forecast for all of next year to -0.4%, below consensus, with all four quarters representing contraction.
Earnings season so far not too bad but the “anvil” has just begun to fall
The best way to describe the earnings season so far is that, although overall earnings per share are up only 3% year over year (and down 3% ex-energy), it’s not been as bad as some feared. So far, companies are adjusting to wage pressures and the impact of the strong dollar through a combination of pricing power, hedges, efficiencies, and share buybacks. And analysts’ S&P earnings forecasts for next year, while down from the $247 EPS level they had estimated back in January, are still a solid $238. Our own forecasts at Federated Hermes are a much lower $200. Our view is that rather than representing stabilization, earnings have only just begun to be cut. For instance, the tech sector, where Covid-driven lockdowns and consumption shifts powered expectations of ever higher 20%+ growth, has only just begun to scale back expectations and should see another big downshift in Q1 as demand for cloud services and other hot areas soften further in the rocky economy ahead. The industrials space, in addition, should see further reductions as companies sharpen their pencils on 2023 guidance. So, as noted in our recent piece, “The anvil that could be coming,” we think it unlikely the market will make an enduring low until earnings expectations for next year have become more realistic. That process has begun, but it still has plenty of room to go.
Fed could soon signal a scaling back of aggressive rate hikes but cuts still far off
With tomorrow’s fourth 75 basis-point hike of the year a near certainty, it seems likely that either tomorrow or soon thereafter the Fed signals that it will begin to measure out its rate-hike medicine in smaller increments, perhaps 50 or even 25 basis points. While this would be good news for sure, we differ from consensus expectations that such a suggestion would presage an impending pivot to lower rates and by extension, improved equity valuations. While the spring of 2023 should start to see nominal inflation readings come off hard as we lap the big jump in oil prices earlier this year, other core inflation pressures (supply shortages, housing shortages/rental price increases, and labor shortages/wage increases) are likely to keep core inflation readings in the 3.5-4% range most of next year—down from the 5-6% currently but nowhere near the Fed’s 2% goal. In this environment, a Fed reading off the 1970s’ playbook that cut rates too soon and left the inflation beast alive to live another day, seems very unlikely to begin a rate-cutting cycle anytime soon. Indeed, even to suggest it might do so could unleash expectations of future price rises that the Fed needs to dampen. So for us, a pause is far from a pivot, and relief in valuations on long-duration equity assets is unlikely anytime soon.
Sometimes, when consensus is almost uniformly bearish as it was at the lows on Oct. 14, all it takes for markets to rally is for what has been uniformly bad news flow to just get less bad. And in some cases, that’s been the case. However, the consensus in our view has been way too trained via the last 15 years to anticipate sudden, “V-shaped” turns in the economy and Fed policy. And if a “V turn” is coming via Fed policy turning dovish and/or core inflation data heading sharply lower soon, the market rightly can and should move higher, perhaps even back to the old highs of last year. We don’t expect this. Rather, we think 2023 is likely to prove a rocky landing for the economy, inflation and earnings, keeping stocks stuck more or less in the 3,400 to 3,900 fair trading range we’ve been projecting. There will be a time later next year, perhaps, to get more constructive, but in the meantime, we are continuing to recommend remaining at max or near-max overweight to defensive dividend-paying stocks, max underweight to growth stocks, significantly underweight bonds and max overweight to cash/money markets. (This positioning, by the way, has interestingly even outperformed in the present rally, with defensive stocks modestly higher than the growth indexes.)
After all, even rocky landings can have big bounces.