12.07.2022 An across-the-board rate rise has rocked the S&P 500 this year. Though the Index is down a bit more than 15 per cent at this point, it is more than 10 per cent higher now than it was in October, fueled in part by optimism that the peak in overnight rates is only a few months away. Meanwhile, companies are under pressure to maintain their profit margins in an economy in which all their input costs are on the rise. For most firms, input costs comprise varying combinations of capital, labor and commodities. When measured on a year-over-year basis, intermediate corporate borrowing costs are more than two percentage points more expensive, private company wages have expanded by 5.1 per cent and commodities are 23 per cent costlier. While companies have raised their prices, not all their costs could be passed along, so profit margins are falling. Are forward earnings expectations aligned with reality?

Large Cap Profit Margin Graph

The yield differential between the two-year and the 10-year Treasury notes inverted earlier this year and has gotten increasingly inverted recently. At negative 0.83 per cent, today’s Treasury curve is the most inverted it has been since the 1980s. The inverted yield curve has predicted the last six recessions without false signals. At the same time, households are burning through the cash stash they accumulated in 2020 and 2021 through generous unemployment benefits, stimulus checks and child tax credit payments. Households were able to amass roughly $2.3 trillion in excess savings, according to the Financial Times. Now, we estimate that stockpile has been cut in half. Other households have been increasingly relying on credit card debt to supplement their spending. Credit card debt grew by 15 per cent over the last 12 months, according to Federal Reserve data.

10-Year Minus 2-Year Yield and Recessions

With the bond market calling for recession, analysts are marking down their profit expectations. Virtually all the S&P companies have reported and Q3 profits look to have expanded about three per cent over the last four quarters, representing the slowest profit growth since Q3/20, according to The Wall Street Journal. Now analysts are penciling in a two per cent profit contraction for Q4.

The problem is, the combination of higher costs and lower revenues could hit corporate America hard.  The average earnings contraction over the last nine recessions (dating back to 1957) was nearly 20 per cent. That’s a far cry from the mid-single-digit profit growth analysts anticipate over the coming year.

YoY Earnings Chart

While earnings are an important element in equity market valuation, interest rates are equally important because they determine the market multiple (the P/E ratio). A recession next year would undoubtedly usher in a sizable earnings contraction, but lower interest rates could cushion the blow.  Our S&P 500 valuation table suggests a 13 per cent profit decline would equate to a 15 per cent market pullback, all other things being equal. If the profit decline were coupled with a half-point decline in rates, the implied market decline would shrink to six per cent.

S&P 500 Valuation Table as of Dec 6 2022

Cresset’s copper-gold model suggests the 10-year Treasury yield should be more than one per cent lower than current levels. All other things being equal, that would imply a 30 per cent rally from here.

Bottom line: We expect a modest recession next year coupled with an earnings contraction that is currently not anticipated by analysts or the markets. However, we expect lower interest rates to cushion the negative impact of lower earnings. All told, we remain cautious about adding equity risk here.

10-Year Treasury Yield Cooper/Gold