As the probability of a US recession grows, the S&P 500’s trajectory in 2023 will be one of diminishing profitability and rising values.
The US economy is predicted to enter a recession in 2023 as a result of Fed rate rises. Corporate earnings decline in such an environment due to declining consumer demand and increasing borrowing rates. The stock market’s drop reflects the decline in earnings estimates across industries in 2022. The value of most enterprises has fallen, but altering dynamics in 2023 may present a different image for US shares; the conflict between earnings and prices may produce market volatility.
“As recession risk looms in the US, the trajectory for the S&P 500 in 2023 will be a case of earnings contraction and valuation growth,” is what Dylan Cheang, Strategist, DBS Bank argues in the DBS 1Q23 CIO Investment Outlook headlined ‘The Return of 60/40’. Here are some more report snippets.
The street lowered its projection for US earnings in 4Q22 (as of 22 November) by 1.2%, with Financials (-6.2%), Materials (-6.4%), and Consumer Discretionary (-4.3%) seeing the most significant revisions.
Despite the downgrades, there is still much too much optimism in the market today. Even if recession chances are increasing, Wall Street expects profits growth of 7% for 2023.
According to our data, in the case of a “moderate” recession, US incomes generally fall by 10% on average.
The apparent disparity between expert estimates and economic realities on the ground, we believe, can be ascribed to two factors:
| 1 | While the Fed has begun aggressive monetary tightening, the impact on the broader economy has yet to be completely conveyed, so there is still an element of “cautious optimism” in the market. |
| 2 | Before lowering profits, equity analysts are looking for more clarity on the economic outlook as well as guidance from company management. The fourth-quarter reporting season will reveal further specifics about how the Fed’s monetary tightening has impacted business profitability. |
We anticipate additional profit downgrades in early 2023 as analysts begin to factor in the possibility of top-line weakening (due to a “mild” recession) and margin contraction (due to persisting inflationary pressure) over the year.
As more information about the US economy emerges in the coming months, unfavourable profit revisions are anticipated to gather traction. Overall, the S&P 500’s trajectory in 2023 will be influenced by the crosscurrents of earnings contraction and value increase.
Our essential assumptions are as follows:
- The Fed is taking a dovish stance as the US economy slows. Lower bond rates, and hence a lower risk-free rate, will result in value growth.
- We estimate ahead P/E mean reversion to its 5-year average, which amounts to an average valuation growth of 8% in the US (about similar to the average valuation expansion of 7% seen during periods of “moderate” recession).
- Sectoral profits growth presently averages 8%, which we believe is excessively optimistic. Now, if earnings fall by the historical average of 10% owing to recession, the earnings reduction will be more than compensated by valuation expansion.