Investors should remember that the S&P 500 is not the US economy.
US recession fears have spiked recently, with worries about the state of the labour market leading to volatility in equity markets. At face value, a slowing economy would seem to contradict the view of equity analysts, who are currently forecasting a broadening in US profit growth after several quarters of dominance by the ‘magnificent seven’.
However, the detail within these forecasts is important. Picking through the earnings outlook, it is plausible that earnings do broaden out as the US economy slows.
An outright recession would be more of a challenge, though this is not our base case. Investors should nonetheless be aware of downside risks to the economy, and that risk assets are likely to remain especially sensitive to economic and earnings data.
Resilience in equity portfolios will therefore require balance. This includes diversification by sector and style, as well as across cyclical and defensives, and a focus on quality companies.
The economy is not the stock market
Over 2023 and the first half of 2024, only a handful of stocks in the S&P 500 index saw their earnings grow. The magnificent seven companies grew their profits 31% year on year in 2023 as global technology demand surged, whereas earnings in the rest of the S&P 500 actually contracted.
Yet this was the year in which the broad economy grew by over 6% in nominal terms. This disparity between the performance of the US economy and corporate earnings is important, and is central to why we think it is possible for activity to slow while profits broaden.
Digging into the detail of today’s earnings forecasts reveals why. Profit growth in the magnificent seven and the rest of the S&P 500 is forecast to converge meaningfully by the final quarter of 2024, which would represent a major pick up in earnings for the non-megacap firms.
Much of the positivity baked into these earnings forecasts reflects idiosyncratic, sector-specific tailwinds. For example, some industries – such as energy and materials – delivered exceptional earnings growth in 2022, with profits boosted by a spike in global commodity prices. Healthcare also saw strong earnings growth thanks to Covid-related demand. However, this strength was paid back in 2023, as the level of earnings per share in these sectors normalised.
As this payback period fades, profits in these industries are forecast to improve meaningfully – one factor behind consensus forecasts for broader earnings participation.
Elsewhere in the US equity market, slowing wage growth is expected to be particularly positive for labour-intensive industries. These sectors have recently faced a margin squeeze, as US labour costs were slower to fall than inflation – a challenge for sectors less able to pass on cost pressures, such as industrials and consumer staples. But as wage growth continues to normalise, margin pressures should recede.
Finally, an improvement in the global manufacturing cycle is expected to support broader earnings growth. After a period of pandemic-related strength, global goods demand eased meaningfully in 2023. But gains in manufacturing sentiment indices suggest the demand picture may be improving, which would be a boost for the industrials sector in particular.
Looking further ahead, while we do anticipate policy rate cuts from the Federal Reserve over the next 18 months, we also expect interest rates to settle at higher levels than seen over the 2010s. Alongside a slowing, but not collapsing, US economy, this could also support financials’ earnings as net interest margins remain stronger.
Slowing fine, recession more of a challenge
While we think a slowing in US activity doesn’t necessarily contradict current earnings expectations, a recession would clearly challenge today’s forecasts for broader earnings growth across the S&P 500 index. Sectors such as industrials and financials would struggle to reach today’s consensus profit numbers in a period of intense consumer weakness.
However, a period of significant economic weakness is not our base case. Corporate fundamentals remain strong, and layoffs are still muted. Part of the recent increase in the US employment rate is down to strong immigration and participation, rather than solely down to rises in the number of unemployed.
Even if the US does see a slowdown, we don’t see the excesses that typically create a nasty downturn. Household debt levels are contained, and investment levels have been moderate.
Conclusion
We do not see reasons to be concerned about the fundamentals of the US equity market. Consensus US earnings forecasts don’t look overly optimistic given our base case of a slower – rather than collapsing – US economy. Investors should remember that the S&P 500 is not the US economy.
Nonetheless, markets will remain reactive to incoming data given perceptions of increased recession risk. Investors should therefore check in on their equity allocations to ensure their portfolios are not overly sensitive to potential earnings disappointments, or to volatility in economic expectations.
Balance is key. Diversification across sectors and styles, as well as a focus on quality companies, looks prudent given still-high uncertainty about the path ahead.