In the first half of 2022, equity markets posted their worst performance in decades, reflecting investor concerns about inflation and recession
- Still, second-quarter corporate earnings are better than expected, driven by the energy sector, continued strong revenue growth and broadly resilient margins
- Assuming the US economic slowdown remains moderate, we believe earnings growth expectations could decline further while remaining positive for 2023
- Given our asymmetric option strategies, we remain underweight equities and remain focused on quality stocks.
There seems to be a gap between profit expectations and economic reality. Investor concerns about record inflation seen in early 2022 were compounded by supply concerns and China’s zero-Covid policy, as well as demand-driven commodity prices in the wake of the pandemic and war in Ukraine. Adding to these fears is now the risk of a recession as central banks seek to slow economic activity through higher borrowing costs.
With inflation at its highest in four decades, the Federal Reserve is raising interest rates to dampen demand. Recent polls show that consumers haven’t shown such pessimism since 2014. By conventional metrics, the United States has already entered a recession: in the first half of 2022, the country’s economy contracted for two straight quarters. Concerns about sustaining industrial and consumer demand are compounded by geopolitical tensions, including the war in Ukraine and its impact on food supplies and energy markets, which are now compounded by tensions between the West and China.
In such an environment, it is not surprising that the S&P500 index posted its worst half-year performance in almost 50 years, falling more than 13% year-to-date after recovering around mid-June. During the same period, other U.S. stock indexes, including the Dow Jones Industrial Average and the tech-heavy Nasdaq, fell 10% and 20%, respectively.
This development reflects the fears of investors, who are faced with many uncertainties, rather than company results, which remain largely positive. These were supported by strong demand and, in some sectors such as energy and materials, high commodity prices. While 80% of S&P500 companies have already released their second-quarter results, nearly three-quarters of them beat earnings-per-share (EPS) growth estimates, albeit by narrower margins than expected in the first quarter. Earnings growth is about 10% higher in the United States than in the second quarter of 2021 and more than 20% year over year in Europe.
Forecasts remain positive
However, a large part of this development can be attributed to the energy sector. Excluding the latter, annual EPS growth is negative in the US and just 6% higher in Europe. EPS estimates for the rest of 2022 and especially 2023 have been falling since early June (see chart). However, they remain above the level of early 2022. Despite the expected recession in the United States, forecasts continue to point to positive EPS growth in 2023.
How long will markets reflect economic fears rather than business reality? If we look at how long it took for markets to bottom out over the past sixty years, we’ve identified fifteen periods in which the S&P500 has fallen more than 15%. Eight of these occurred during recessions, with the median peak-to-trough declines lasting fourteen months and averaging a 35% decline. Outside of recessions, the decline from peak to trough was twice as fast, with a median decline of 19.4%.
Therefore, based on these historical averages and the pullback of the S&P500, another 10-15% drop in the index from its recent lows is statistically possible if we enter a severe recession, and half that level if the slowdown is mild. We believe we are witnessing a cyclical bear market with no threat of major corrections due to macroeconomic imbalances. As far as history shows, the average maximum loss in such a setup has been just over 29%, with bear markets lasting an average of 21.6 months. In terms of timing, historical averages suggest that markets are anticipating economic realities, bottoming out about six months before economies emerge from recession.
Earnings, which have already started to adjust, have room for another decline. Expectations appear consistent with a mild and manageable recession in most sectors that will adjust to current supply and cost challenges. For now, demand looks robust as households still have post-pandemic savings and many of the strains are already priced into the outlook. Additionally, company margins still look healthy and consensus forecasts still point to improvements in 2023 as companies have so far managed to pass on higher capital costs. That could change if rising labor costs begin to weigh on margins, but after an exceptionally difficult first half of 2022, investors are regaining confidence in company valuations and the prospects of their executives.
Of course, this situation is severely distorted by the energy crisis and may even get worse. While many energy-intensive sectors such as car manufacturing have faced increases in their energy-related production costs, the worst, including possible restrictions or rationing, could come in the northern hemisphere as winter approaches, with low gas reserves and high oil prices.
US interest rate hikes – a fifth hike of 75 basis points expected in September – will continue to dampen US growth. Rapidly rising prices are already forcing households to spend more of their income on basic necessities such as heating, fuel and food. This suggests that the likelihood of another contraction in GDP and a US recession in early 2023 is increasing.
For now, job vacancies remain high and the unemployment rate is nearly 3.5%, its lowest level in 50 years. That situation is bound to change as companies like Walmart and Microsoft respond to the slowing economy by shedding jobs.
However, as economic data continues to deteriorate, investors appear increasingly confident that indicators will lead the Fed to halt or even reverse its rate-hiking cycle in 2023. As inflation is set to stabilize, the sooner the economic slowdown becomes more stable investors are satisfied with stock valuations.
For now, our positioning on equities is bound to remain cautious. We maintained our positions in ‘value’ and quality stocks, which we believe companies are better suited to the ‘lower growth and higher interest rates’ economic environment or better able to defend their margins. Regionally, we have increased our exposure to US quality stocks and continue to favor the UK, where value stocks are plentiful, and Chinese stocks. Finally, we maintain asymmetric hedging strategies to take advantage of market gains while managing downside risk in American and European markets. Of course, we are closely monitoring this week’s inflation data for positive signs that monetary policy is easing price pressures. In general, any sign of a stronger economic contraction would prompt us to review our portfolio positioning.
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