For equities markets, falling profits are an inconvenient truth. S&P 500 EPS fell at a 14% annualized rate in 2H 2022, and we expect declines to persist near that pace through 1H 2023.
Dramatically stronger US data for January – a “lull period” for actual business - underscores the difficulty in tracking the true path for the economy during the seasonal extremes of the year. Historically, January and July are the only months that have experienced historic revisions to US employment of larger than 300,000. Did US retail sales really surge at a 36% annualized rate in January? Without adjustments, sales fell 16% from December 2022, a normal seasonal drop.
We don’t believe US labor markets have either accelerated or weakened yet. Layoff announcements are mounting, but many who have lost their jobs are likely still on their company payrolls, particularly in tech industries. Surging business inventories and unsold homes point to slowing US labor demand in the coming year and reduced upward interest rate pressure.
The “kick-back” rallies of January gave the appearance of a benign “Goldilocks” scenario for the economy and monetary policy. The sharp rally in the lowest quality credits and unprofitable firms seemed driven by short covering, rather than a new economic recovery.
In February, world markets have been set back by renewed rate fears on the strong data. Weaker data for the late winter/spring may provide relief. However, this won’t leave room for a Goldilocks economic outlook over the near term.
A bottom in equities markets should come this year in anticipation of economic growth in 2024. However, downward EPS revisions may remain a challenge through midyear, and we still expect a 10% EPS decline for calendar 2023.
While we might be premature, we would expect the spring quarter (2Q) to see the fastest rate of economic contraction as firms address high inventories by slashing production. Labor markets will likely weaken in a lagged fashion during this time and perhaps deliver a “jobless recovery” in 2024. Given a modest recovery to date and labor force constraints, we don’t believe the US jobs market is vulnerable to large losses or is likely to see strong gains.
The reality for cyclical equities should be sharp downward revisions in EPS estimates for the calendar 2Q period as analysts predict an implausible 31% annualized gain from the first quarter pace. They go on to predict a new record high for quarterly US profits by 4Q of this year. We believe this is far too soon.
We still believe the worst of the bear market losses were felt in 2022, but we stay defensively positioned. Some investors see either a swift return or continuation of strong economic growth and low inflation despite a rapid US monetary tightening cycle with many other central banks following suit.
Real US yields (+1.5% to 2.0% in TIPS markets) are historically attractive in the current backdrop, as are investment grade corporate bond yields (5.8% for nominal long-term issues, greater for hybrid securities).
Our largest off-index allocations in equities remains to the most consistent US dividend growers and pharmaceuticals firms. These are not, however, the likely leaders of a new early cycle bull market. When conditions are right, we would expect to shift our allocation toward riskier equities and continue raising the non-US share of our portfolios in time.