If we have a recession, it'll likely be a 'rich' one
Three things to watch in 2024.
All about margins U.S. corporations generated a record $3.4 trillion of annualized cash flow in Q3, not only because of stronger-than-expected growth but also because profit margins have been climbing since 2022. There are reasons to expect margin expansion to continue in ’24, including: moderating wage increases as labor conditions loosen further; a smaller bite from interest rates as they move off their highs (on top of the fact many larger companies already termed out debt before the run-up, with net interest expense as a percent of sales averaging 2% from 2008-2022 vs. 3.8% from 1994-2007); and rising productivity (it hit a 2-year high in Q3) as companies increasingly incorporate AI and other efficiencies into operations. As much as they’re worried about the economy, managements say they’re positive about their own companies. Corporate earnings inform business decisions (hiring/firing, capex, travel, etc.), and analysts have been raising estimates for next year and ’25. A risk: monetary policy begins to really bite, companies are less able to pass off stubborn costs, margins are increasingly pressured and layoffs take off, leading to a “richsession.”
“Richsession” That’s Bank of America’s word for what could happen if layoffs among higher-income earners ($125k+) continue to rise. These consumers have been carrying the spending load of late as lower-income cohorts pulled back amid higher prices, higher (and higher cost) debt and moderating wage growth. A recent Deutsche Bank analysis concluded that contrary to reports, labor hoarding is unlikely in the U.S. if growth begins to slow notably. Instead, under those circumstances, it expects U.S. companies to shed jobs at a more aggressive rate than in past slowdowns. Pay disruption caused by job loss has been rising all year, led by finance, media and technology industries. And moves between jobs have fallen sharply across generations, most notably for younger people. Of those who did change jobs, the associated pay jump was almost halved vs. a year ago (10.8% vs 18% in ’22), with millennials experiencing the biggest drop-off. And by income, Bank of America says the largest decline was among those earning $100k+. That’s the area that matters most to the economy.
The more breadth, the better No surprise the S&P 500 equal weight index, a proxy for the average stock, posted its worst relative performance this year relative to the cap-weighted index since 1998. It was the year of the Magnificent Seven, after all. But history shows the last time the equal weight index underperformed so handedly (in 1999), it went on to outperform the cap-weighted S&P for almost the entirety of the 2000s. There already have been some signs of late of reversion—the average stock since mid-November has closed the performance gap with the mega-cap tech stocks by roughly 300 basis points, helping lift the total year-to-date return of the equal-weight S&P to 8.1% through early December. That still significantly trails the cap-weighted index return of 21.5%, but it’s a lot closer than a few months ago. The performance differentials between Value and Growth stocks are even wider and again, at levels last seen in the late ’90s. And again, the gap between the two styles reversed early in the new millennium. The market may have begun to broaden—since the late October correction bottom, five S&P sectors have outperformed the index (Real Estate, Financials, Consumer Discretionary, Information Technology and Industrials), and small and mid-caps have outperformed. Profit margins surprised this year but many stocks weren’t rewarded. If investors take notice of “bargains,” breadth could widen for a continued bull run. Broader is better for the market.