Economic and Market Review: Long-Term Optimism Amid Short-Term Headwinds

Many equity investors have two burning questions right now: 1) why is the economy not in a recession, and 2) why has the market rallied since October?

As discussed above, falling but elevated inflation has created a disconnect between nominal earnings and the real economy. Strong nominal growth appears to have captured investors’ attentions: In Q1 2023, the nominal economy grew at 3.6%, while the real economy shrank 1.2%, and on a trailing-12-month basis, nominal growth reached 5.7% versus real growth of 0.3%⁵ Little surprise that investors looking through a rosy nominal-earnings lens might wonder whether all the talk of an extended downturn had been overblown. However, consensus nominal growth is expected to decelerate through the end of the year as headline inflation recedes, which may likely put profit margins under pressure now that real wage growth has turned positive.

On a more somber note, we find economic growth is faltering and the economy appears destined for a recession as temporary drivers that helped defy the gravitational pull of tightening credit conditions begin to fade.

• First, while real disposable income jumped in Q1,⁶ the increase was driven by an upward adjustment to social security payments—a one-time, ephemeral boost, in our view.
• Second, the global PMI rebounded in 1Q along with European and Chinese growth, while the U.S. dollar fell.⁷ Both shifts put wind behind large multinational companies, especially the FAANGs (including Meta, Apple, Amazon, Alphabet, NVIDIA, Microsoft and Tesla), whose earnings benefit from a falling USD.⁸ However, the rebound in global PMI has since reversed, and the USD (a countercyclical currency) appears, to us, in the process of strengthening.
• Third, global central banks supplied $1.3 trillion of incremental liquidity over the last two quarters to stem an array of issues, from a banking crisis in the U.S. to a lackluster post-lockdown recovery in China (see the left chart in figure 3). We believe that while a shot of liquidity helped fuel a rally in more speculative investments, such as Bitcoin and AI-linked equities, it does not appear to represent the beginning of a longer-term easing cycle. Instead, we think global central banks’ balance sheets are set to shrink by $1 – 1.5 trillion by the end of the year, as central banks with accommodative policies (the PBoC and BoJ) only partially offset those with a tightening bias (the Fed, ECB and others DM central banks). Shrinking liquidity, in our view, could remove an important pillar of support for the recent rally.

Figure 3: Global Central Banks Aided the Rally, but Fiscal Policy May Not Sustain Further Growth

 

• Fourth, while a sizable corporate order backlog has driven U.S. economic activity since mid-2022,⁹ those backlogs have now normalized and, in our view, are unlikely to support growth going forward. Also, capex growth overshot relative to weakening credit availability in Q1’23.¹⁰ While Q2 data is forthcoming, the latest Flow of Funds report from the Federal Reserve shows that corporations have been drawing down cash deposits at a slower rate, suggesting to us that the capex catalyst has also lost steam.¹¹
• Lastly, despite large spending programs such as the Inflation Reduction Act, U.S. fiscal stimulus will be more modest this year than last. And it’s not just the U.S.: We find that, in the coming year, the net growth impulse from fiscal spending will be negative in 12 of the 14 major economies (see the right chart in figure 3).

As the tailwinds that supported the overall economy, and FAANG stocks in particular, continue to fade, we believe the lagged impact of tighter monetary policy is set to intensify. Consequently, we expect U.S. growth to downshift and reconnect with the recessionary track it was on and lead to increasing volatility in the equity market.

Our base-case view on equities calls for asymmetric risk to the downside—meaning that if we’re wrong, the markets might move up modestly, but if we’re right, the recessionary decline could be significant. While we maintain our cautious stance and conviction in our analytical framework, we also continue to interrogate our underlying assumptions and aim to anticipate unforeseen outcomes.

We see three main risks to our prognostications. First, consumers may keep spending at a healthy clip; second, companies—especially mega-cap stars—could keep making piles of profit; and third, oil prices could drop, spurring temporary growth. All of these effects, while not probable in our view, could sustain the equity rally and stave off a broader downturn.

Bullish Case #1: Persistent Consumer Resilience

Despite higher levels of inflation, real disposable income (RDPI) could turn up and counter the Fed’s monetary tightening. In this scenario, strong RDPI—combined with a 30-year low in consumer indebtedness—could support consumption and lower the likelihood of a recession, or at least mitigate its severity. That strong consumption could also offset credit tightening as consumers, especially those in the top quartile—where dis-savings momentum has been particularly strong—work through an estimated $1 trillion in excess savings.

Wealth effects could spur spending, too. The wealthiest 50% of Americans (who account for about 68% of consumption) appear to feel flush: Total U.S. household net worth is currently $140 trillion, which is about $15 trillion above our estimated pre-COVID trend line; meanwhile, cresting inflation and rising real positive wage growth could ease discomfort and support consumption among the bottom 25%.²²

Our Take

The depletion of excess savings tends to moderate as economic uncertainty rises. Over the past two months, savings depletion has moderated to $65 billion per month from roughly $100 billion per month.²³ Growing evidence shows that U.S. consumers are rebuilding their savings buffers as monetary stresses mount. The U.S. savings rate has picked up and is now at 4.1% compared to the trough of 2.7% in June 2022. Higher savings, we fear, would most likely hinder consumption.²⁴

At the top end of the economic ladder, we think there is enough monetary tightening already in the pipeline to induce a stock market sell-off in the next 12 months, which could cause top-quartile consumers, who we estimate account for roughly 40% of total consumption and whose consumption patterns strongly correlate with their net worth, to rein in their post-COVID profligacy.

If consumption does manage to stay strong, we fear it could drive up sticky inflation in the absence of rapidly expanding labor supply. If this happens, we believe the Fed would be forced to resume rate hikes until demand cools via the net reduction in employment or the negative wealth effect from falling stock prices.

We believe a notable difference between this slowdown and previous ones is the pain felt by high-income workers from anemic real wage growth, hiring freezes and layoffs in high-paying sectors, such as TMT and Financials. Retail sales have declined in eight out of the past 12 months, while earnings transcripts reveal that inflation-squeezed consumers across the income spectrum are increasingly “trading down” in favor of less expensive brands. Indeed, mentions of weak demand spiked to near-record highs among Consumer Discretionary companies.²⁵

Meanwhile, we believe overall financial stress is simmering. As more consumers rely on credit to cover living expenses, credit card balances have grown four times faster than the pre-pandemic average, and 30% faster than the September ’22 to January ’23 trend line; now the cracks, in the form of rising auto and credit card delinquencies, are starting to show (see both charts in figure 7). Finally, leading employment indicators appear to suggest to us that net job losses and a pickup in the unemployment rate is imminent.²⁶

Figure 7: Financial Stress Is Starting to Simmer as Credit Balances and Delinquencies Rise

 

Bullish Case #2: Persistent Corporate Resilience

We think there are two scenarios in which corporate America could prove surprisingly resilient and extend the bull rally.

Scenario #1: Mega-cap growth stocks carry the day

As of mid-June, seven MEGA companies represented 28% of the S&P 500 market cap and 17% of earnings.²⁷ If MEGA earnings—now at the bottom end of their collective trend channels—stage a rebound, they could pull the rest of the index with them.

Indeed, we believe many investors now perceive MEGA stocks as semi-utilities of the modern economy and price them as defensive stocks.²⁸ As sales slowed from the stratospheric post-COVID peak, many of these giants reduced headcount to match their slowing growth (with room for more cuts if necessary), which could support their margins in the future and make them effectively less cyclical. This scenario could lead to a shallower S&P 500 earnings decline than we have been expecting.

Our Take

While it’s possible a frothy mix of momentum chasing and irrational exuberance over AI could coax the S&P 500 to levels last seen in January 2022, we think valuations still look overvalued. At a relative P/E ratio of 1.8, MEGA stocks are more expensive relative to the rest of the S&P 500 than they’ve been since 2003 (see the left in chart figure 8). MEGAs also appear very dear in terms of the equity risk premium (ERP): Even after accounting for their higher EPS growth expectations, the NASDAQ 100 index (an excellent proxy for MEGAs) hasn’t been as richly valued relative to the ERP since 2011.²⁹ And while MEGA earnings tend to be only about half as sensitive to the economy versus the rest of the S&P 500 (a defensive trait), their average beta of 1.2 implies they are still quite sensitive to swings in the index.³⁰ In short, we fear MEGAs may not offer as much cushion in a recessionary downturn as markets may hope.

Figure 8: Megacap Growth Stocks Appear Dearly Priced vs. The Rest of the Market

 

Second, we worry that tech revenue is more cyclical than investors might appreciate. For instance, the revenue surprise ratio for MEGAs closely tracks the trajectory of ISM new orders (a cyclical indicator), with a lag of three months (see the right chart in figure 8); also, cyclical and global indicators such as the developed markets PMI and the U.S. Dollar explain well over half the variation in tech sector earnings, yet both measures are now moving in the wrong direction for the sector.

Adding to the potential cyclicality is the sector’s sizable exposure to the financial services sector, which accounts for 20% of tech revenues. For context, consider that the IT demand pull-forward during COVID was as extreme as during the run-up to Y2K (when banks were concerned about systems functioning past 1999); yet the frenzy quickly subsided, and tech sales dropped by 28% over the next six quarters.³¹

Scenario #2: Monetary tightening has weaker negative impacts

Historically, tighter credit tends to curb capital expenditures, denting earnings across the industrial supply chain. Yet given broadly modest capex layouts over the past 10 years, the sensitivity of capex to credit could be lower this time around. Post-GFC, 38% of cash flow was spent on capex (vs. 52% pre-GFC), 21% on dividends (vs. 17%), and 24% on share buybacks (vs. 13%);³² furthermore, industrial companies have substantially de-levered since the GFC, suggesting limited debt-driven PP&E investment over the past 10 years.

Corporate balance sheets could also prove surprisingly resilient. In the aggregate, acceptable leverage and higher-than-average cash levels could help blunt the pain of monetary tightening.³³

Our Take

Even though leverage in the aggregate is reasonable, corporate leverage among the 20% most-levered companies in the S&P 500 is at a historic high,³⁴ which could make them financially vulnerable to the Fed’s aggressive monetary tightening.

Meanwhile, over the last two quarters, operating leverage has turned decisively negative across the S&P 500 (excluding the energy sector) as costs have grown faster than sales. Companies now appear especially dependent on raising prices to offset falling margins and sales volume, even as consumers continue to trade down and reduce unit consumption. History suggests that it is difficult to maintain margins amidst weakening demand, which eventually leads to a downturn in earnings.

As things stand, consensus earnings—measured in nominal terms—are 9% above their normalized trend level,³⁵ and growth expectations remain aggressive. Even growth sectors that cut estimates in 2022 still have significant margin improvement penciled in; for example, the consumer discretionary sector, which tends to be significantly affected by monetary tightening, is expected to grow 21% over the next year.³⁶ Despite this enthusiasm, we worry that disinflationary recessions can be particularly punitive to earnings as companies are unable to pass along price increases and sales volumes dwindle.

Finally, earnings quality remains at a multi-decade low,³⁷ which poses an additional risk to earnings as aggressive accounting accruals get reversed and write-offs potentially start to mount, which has been the case in every economic downturn over the past three decades. Write-offs can lead to faster earnings declines than consensus anticipates and ultimately lead to greater declines in stock prices than would be suggested by their historical betas. In the first quarter of 2023, companies that missed sales and earnings estimates were punished at over twice the historical average.³⁸

Bullish Case #3: Falling Oil

An unexpected $25- to $35-per-barrel drop in oil prices could stimulate global growth—as when Brent Crude dipped in the first half of 2006, helping spur growth the following year. We believe a similar decline could trigger a one-time boost to growth, perhaps delaying a recession until mid- to late 2024; eventually, however, cheap oil would likely fuel higher inflation—ultimately pressuring the Fed to raise rates even more aggressively to quash it, thereby choking off earnings growth and investor optimism.

Our Take

In our view. this scenario seems unlikely given current geopolitical tensions, current supply/demand balances, and OPEC’s unwillingness to increase production to bring down oil prices.

Based on their relative sensitivity to changes in inflation and financial conditions, and their historical beta to the stock market, we offer the following as our overweight and underweight views.