04.12.2023 US large caps have enjoyed a smart rebound so far this year, with the S&P up about seven per cent. Last year’s biggest losers have been this year’s largest gainers, with communications and technology stocks more than 20 per cent higher after last year’s 20-40 per cent rout. Utilities and energy shares, last year’s leaders, are under water so far in 2023. Fundamentals will come to the fore later this week when Q1 earnings season begins, and equity investors will discover how big a bite higher interest rates and higher prices have taken out of corporate earnings ‒ and where they can expect the markets to go from here.
If 2022 was a year when markets reacted to higher rates, 2023 and 2024 are years when fundamentals, like economic growth and profits, will feel the effects of one of the most aggressive rate hiking programs since 1980. The yield differential between 2-year and 10-year notes inverted last year, signaling one of the most anticipated recessions on record. Even though the US has not yet dipped into economic retrograde, Wall Street is bracing for a profit pullback. Corporate leaders are navigating a challenging environment. Interest rates are getting expensive, labor markets are tight and wages are on the rise. Meanwhile, demand is flagging, and consumers are pushing back against price increases. As a result, margins are under pressure.
First quarter profits are expected to drop eight per cent year on year, according to Bloomberg, representing the steepest Q1 drop since the onset of the global pandemic lockdown of Q2/20. Add the two per cent profit pullback last quarter and an anticipated six per cent profit decline next quarter, and the picture is clear ‒ US large caps are experiencing a mild profit recession.
The profit picture has been deteriorating rapidly. As recently as last quarter, analysts anticipated flat Q1 results ‒ and that’s down from a robust eight per cent expansion as recently as September. Tighter financial conditions, fueled by an aggressive Fed and stricter lending standards, could continue to weigh on earnings growth in future quarters.
Besides higher costs, denuding demand is also to blame for the parsimonious profits picture. Q1/23 will be the first quarter since the pandemic in which sales growth is expected to trail inflation, suggesting a decline in volumes. Last week, Costco surprised investors by revealing a rare monthly same-store-sales decline of 1.1% through March. The warehouse retailer reported 6.8% year-over-year same-store-sales through February. That suggests just 0.8% volume growth when stripping out six per cent inflation over that timeframe.
What does this mean for the market? The S&P 500 derives its value from earnings and interest rates. One-year-forward earnings is the denominator of the PE ratio and the 10-year, BBB bond yield drives the multiple. As 2023 dawned, investors anticipated earnings growth of a little more than three per cent for the year. Discounting those profits at a 3.88% 10-year Treasury yield, plus a modest credit spread, derived “fair” value. Since then, the profit picture has diminished: analysts are now penciling in a 2.3% decline in profit growth this year on weaker growth and margins.
At the same time, the 10-year Treasury yield has pulled back on similar concerns. Its yield has declined from 3.8% to 3.4%, helping offset the earnings decline. The market’s single-digit gain so far this year squares with our S&P 500 valuation model, begging the question: where do we go from here? Today’s return is currently situated at our year-end target, suggesting sideways trading for most of the rest of the year. The stock market’s direction will depend on inflation, interest rates and earnings growth. From our vantage point, a choppy sideways market will likely characterize the remainder of 2023.