2022 was a year characterized by extreme capital market volatility. Uncertainty around the trajectory of inflation led interest rates to rise sharply, undermining equity market valuations that had been sitting well above long-term averages. Looking ahead to 2023, we are faced with three questions: What is the outlook for earnings? Do valuations have further to fall? And when will volatility decline?
The outlook for earnings will depend on the evolution of economic growth; if a recession can be avoided, we would expect earnings to be roughly flat relative to 2022 levels. However, if the U.S. economy falls into recession, history suggests earnings could decline by as much as 15-20%. Perversely, stubborn inflation could support earnings. With inflation only gradually decelerating, rising prices will continue to offset higher costs in certain industries, leaving margins as the key driver of earnings. While margins will continue to decline, they should settle around 10%, rather than falling to the long-term average.
Profit margins look set to revert to the trend rather than their average
S&P 500 quarterly operating earnings/sales
If earnings are expected to be flat to down, how much will investors be willing to pay for these earnings? Although the S&P 500 forward P/E ratio now sits near its long-run average, valuations will decline further if a recession begins to materialize. However, it is not clear that valuations need to retreat to levels seen during the Global Financial Crisis, as the combination of a mild recession and the higher quality nature of companies suggests markets could find support at higher valuations than in the past. Furthermore, as slower expected growth leads bond yields to decline, equity valuations should find additional support.
Although the outlook for risk assets is improving, plenty of questions remain unanswered. We have seen peak inflation, peak Fed hawkishness and (hopefully) peak geopolitical tensions, but these issues have not gone away and will remain as a source of volatility. However, if we do experience a mild recession next year, markets will begin to look to the coming cycle well in advance of the economic data improving. In fact, since 1960, the S&P 500 has bottomed an average of 6 months before the unemployment rate has peaked. As such, there is light at the end of the tunnel, but it is not clear how long the tunnel might be. Until we have that clarity, we prefer companies with pricing power and consistent cash flows that are trading at reasonable valuations.