Key Questions: What Does 2023 Hold for US Equities?
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We expect the emphasis to be on earnings this year and have outlined three potential paths that the market could follow; that does not mean any of them will be correct.
2022 was a tough year for US equity investors; however, the weakness in stocks can be chalked up to one simple factor: higher short-term interest rates. After roughly a decade of the Federal Reserve (the Fed) pinning its policy-controlling interest rate at zero, short-term rates rose in 2022 with unprecedented speed as the Fed sought to put the inflation genie back in the bottle.
Equities can be viewed as long-duration assets. In theory, their current value is calculated as a discounted stream of future cash flows. When the rate used to discount these cash flows moves higher, as in this year’s tightening cycle, the inevitable result is that future cash flows are worth less in today’s dollars. If rates are moving higher, this means investors are willing to pay less today for the same stream of cash flows than they were yesterday.
We often see this concept expressed as the price-to-earnings ratio of the market, or the market’s multiple, the price at which investors are willing to pay for a dollar worth of earnings.
Over the past 10 years, the average forward earnings multiple for the market has been 17.1 times earnings (x), with a standard deviation of 2.4x. In 2022, the market multiple declined from roughly 21.5x at the start of the year to 17.5x, bottoming out just above 15x in October. Over the same period, forward 12-month earnings grew from $222.50 to $230.00 after peaking near $239.00 in June. Forward earnings are set to exit 2022 with modest calendar-year growth of 3.3%, so you can see this year has been all about the compression in the multiple that investors are willing to pay for those earnings.
In stark contrast to 2022, we believe that 2023 will be dominated by the outlook for earnings. So it is pointless to provide a precise estimate for where the S&P 500 will exit 2023. Instead, we find it more useful to look at the three scenarios for potential outcomes for US equities in 2023: Soft Landing, Inflationary Boom and Hard Landing.
Base Case: The Fed Engineers a Soft Landing
Inflation, the bogeyman of 2022, looks to have peaked across a host of different measures. A variety of factors contributed to the 1970s-style increase in prices, including pandemic-driven supply chain disruptions, a lack of energy sector investment and a tight labor market. These now show signs of moderation. In fact, consensus expectations are for a meaningful decline in headline inflation over the next 12 months, the result of goods disinflation and forecasts of further downside to energy prices.
If inflation remains on a more favorable trajectory, this should eventually allow the Fed to slow the pace of interest rate hikes or modestly lower the peak level of policy-controlling interest rates, or both. Presently, US economic growth remains robust, as evidenced by both continued strong jobs reports and consumer spending even in the face of a relentless tightening cycle. This suggests that as soon as borrowing costs stop going up, the risk of a Fed-induced recession will recede from the forefront of investor consciousness.
Under the Soft Landing scenario, we foresee 12-month earnings at year-end 2023 of $240, roughly 4% growth from current levels. That should be easily achievable. However, we do not see the multiple expanding above the 10-year average in this scenario (17x), which is consistent with financial forecasts, meaning that returns will be muted or up low-to-mid single digits relative to current levels.
Bull Case: An Unexpected Pivot Leads to an Inflationary Boom
The bull case for 2023 also hinges on Fed policy, but not necessarily in the way that most investors think. In our view, the primary upside scenario for the market does not involve a pivot from the current tightening cycle to an easing cycle with rate cuts. We take the Fed at its word that to get inflation down to more manageable levels by pressuring wage growth, policy-controlling interest rates are likely to remain higher for longer. Instead, we see an upward move of the Fed’s arbitrary 2% inflation target as a potential bullish catalyst for 2023.
Why would the market respond positively if the Fed declares that 3% or 4% is the new target?
Markets have a problem with inflationary shocks, not modest inflation in general! Historically, markets have responded favorably to modest, consistent inflation because revenue growth is nominal.
This means that modest inflation-driven revenue growth translates directly to higher corporate earnings. If the Fed were to announce a change in the target and declare victory over inflation, this would likely lead to investors being willing to pay more for future earnings. In such a scenario, we see the multiple expanding to 19.5x, – one standard deviation above what we have experienced over the past 10 years.
Given that we do not see additional earnings upside next year, for 2023 to be a year to remember for the bulls, multiple expansions are a prerequisite. We only see multiple expansions likely in a scenario where some major policy shift such as moving the inflation target is taken, a low-probability event in our view.
Bear Case: The Fed ‘Breaks Something,’ Leading to a Hard Landing
Fed Chair Jay Powell told us that the path to a Soft Landing is becoming narrower. In this scenario, we take him at his word. While inflation moderates from the 1970s levels seen in 2022, it proves stickier than the Fed would like, leading to persistent wage inflation. The Fed is forced to take policy-controlling interest rates modestly higher than the consensus thinks and to communicate that it is going to leave rates at levels that tighten financial conditions until inflation comes under greater control.
Given an unemployment rate of 3.7% and 10.7 million job openings, wage pressures are unlikely to abate meaningfully. With payroll growth currently running more than twice the pace of new entrants into the labor force and weekly unemployment claims below levels seen last summer, we do not see recent data changing the Fed’s inflation narrative.
While the economy remains strong, it weakens materially in 2023 in a Hard Landing scenario. Currently, information technology companies are cutting jobs aggressively. Homebuilder sentiment indicates that this important area of the economy also has come to a sudden stop because of 7% mortgage rates.
In this scenario, it will not be long until other industries follow. When an economic tipping point is close, adverse sentiment kicks in and outcomes tend to become non-linear, accelerating the slowdown.
In a Hard Landing, we see the current decline in 12-month forward earnings deepening, with earnings forecast to exit 2023 at $200, a decline of roughly 15%. This seems drastic, but a decline of 15% would be in line with historical average earnings declines around a recession. Unfortunately, we would also expect the multiple to contract in a Hard Landing, with 14.7x a reasonable estimate, hitting investors with the dreaded double whammy of multiple compression on a declining earnings number.
We do not see a recessionary Hard Landing as the most likely scenario for 2023; nevertheless, it merits serious consideration. A narrow path indeed.
We have defined these three potential paths for equities in 2023:
- Soft Landing: The risk of recession recedes.
- Inflationary Boom: Modest inflation-driven revenue growth produces higher corporate earnings.
- Hard Landing: Earning forecasts could dip as much as 15%.
It is likely no surprise that we do not think the real world will follow any of these scenarios, with Mr. Market preferring to carve out his usual unpredictable path.
However, it is clear that in a year where the range of potential outcomes is probably greater than any we have seen in recent memory, investors should maintain a disciplined approach to both security selection and risk management, while keeping a firm grasp on portfolio construction principles such as diversification. Following this timeless advice should enable market participants to thrive, or survive, in any scenario.
For more information, please contact your advisor.
About Stephen Hoedt
Stephen Hoedt is responsible for the oversight of our internally-managed strategies, individual equity due diligence, equity trading, and both taxable and municipal fixed income due diligence with an emphasis on credit research. Within the Equity Research team he is responsible for coverage of Energy, Industrials, and Materials.
Prior to joining Key, Steve was the Industrials and Materials Analyst for the National City Corporation’s Private Client Group. He began his investment career in 1993 as an equity research analyst with responsibilities for the computer hardware and software industries.
Steve has been quoted in several publications including Barron’s and The Wall Street Journal, and has also appeared on CNBC and Bloomberg TV.