The anvil that could be coming
How much corporate earnings fall could determine where the market bottoms.
Regular readers of this space know that about a year ago, we became concerned about the potential for a “Wile E. Coyote Moment” for equities, particularly growth stocks. Given their strong prospects and seemingly permanent near-zero discount rates, valuations had risen to the moon. Inflation, on the other hand, was running way too hot and, we thought, unlikely to drop back to the Fed’s 2% target anytime soon. So, rates would rise and even as they began to do so, growth stocks might continue for some time running to—and over—the cliff. But it wasn’t until investors realized growth stocks had nothing but air beneath them, and that their valuations were certain to drop, that we finally got this “Wile E. Coyote moment” in the spring, with the S&P 500 plunging briefly to the 3,650 before stabilizing.
Since then, investors, trained by the crises of the last 15 years to look for V- shaped bottoms fueled by abrupt Fed policy reversals, have outdone themselves, looking for evidence of “peak inflation,” peak policy hawkishness and the “pivot” just over the horizon. They’re going to be looking for a while. As this morning’s FedEx earnings surprise reminds us, the cartoon doesn’t usually end quickly. Rather, the inevitable pattern for the hapless hero always seems to be that as he picks himself up from his scary fall and shakes his flattened frame back into form, an anvil drops from the sky and knocks him out.
At Federated Hermes, our fear for markets is not just that rates are likely to be higher for longer, but that out there somewhere in the future is the likelihood that the anvil will fall, in the form of reduced corporate earnings.
So far, so good
Today’s negative FedEx announcement aside, the surprise coming from this month’s traditional heavy spate of pre-quarter-end corporate conferences has been relatively positive. Most companies are reporting relatively stable business conditions and are using cost-cutting efficiencies to offset margin pressures that are out there (higher input costs, higher rates and a slowing economy among them).
But this itself leads us to remain cautious. The reality is that, for the very reasons we’ve thought core inflation, though peaking, would remain high (in the 3-4% range through 2023), earnings seem likely to hang in there. Consumers and financial institutions have entered this Fed-hiking cycle in unusually strong condition. And inventories across the economy, with some notable exceptions such as apparel, remain tight. Ditto labor. So, core inflation is likely to remain stubborn, and corporate earnings to remain broadly stable. What companies can’t pass on in prices, they’re adjusting for in other ways.
And therefore, the Fed will keep on hiking. Pivot purveyors, be forewarned.
For earnings, a “grind” vs. a “pop”
As concerned as we are about the anvil, our own analysts’ read of the coming earnings season is for more of a grind lower in forward expectations rather than a sudden shift down. With the economy bouncing through a rocky landing, earnings broadly are holding up. And we think this time around, without a deep recession, should bottom out between $200 and $220 next year on the S&P—not more than 10% below current run rates.
While this seems not that bad vs. previous recessions, for growth stocks in particular that are priced for robust growth, this could eventually prove to be the proverbial second drop, the anvil if you will. And for those who struggled through 5th grade math, a 17x P/E multiple on $200 in earnings equates to 3,400—the lower end of our 3,400 to 3,900 forecasted trading range.
What to do?
In the longer term, we remain committed to stocks as the best way out of the present stagflationary environment. Companies’ revenue bases, sooner or later, adjust to the nominal level of GDP, which continues ever higher. And sooner or later, companies’ respective competitive positions will get them back to the profit margins they’ve previously earned. So, however soft 2023 earnings are likely to be, somewhere out there, in 2025 or 2026, $300 awaits us. And with it, an S&P that is nominally higher, even from present levels.
So, even though we are modestly underweight stocks and significantly underweight growth stocks in our balanced models, we remain heavily overweighted defensive value/dividend stocks whose businesses are big, diversified and stable. Their slowly rising dividend streams are likely to produce above-market, and above-inflation returns over the coming three years. We also like cash/money markets over bonds, holding 10% “cash” in our balanced models. With money market returns above 2% and rising rapidly, cash is not a bad way to ride out rocky landings. Particularly when anvils could be falling from the skies.