Interest costs as a share of profits are falling. However, disinflation, slowing economic growth and headwinds to the consumer are likely to constrain revenues.
2023 has turned out to be a surprisingly strong year for equity markets, with the S&P 500 boasting double-digit returns. However, investors should temper expectations for 2024 as estimates for profit growth look lofty, volatility has been unusually low, valuations could come under further pressure and economic growth is likely to slow.
Analysts’ expectations show earnings growing by 11% next year, double the long-term average, while our models are estimating 5-6% growth. Dissecting the sources of earnings growth, margins could maintain stability, but revenues are likely to slow. On margins, pricing power is waning, but input costs and wages are decelerating. Interest costs remain high, but 49% of S&P 500 debt is fixed beyond 2030, with no more than 7% maturing in any calendar year until then. Many S&P 500 companies also maintain ample cash balances, which are earning meaningful interest. Therefore, interest costs as a share of profits are falling. However, disinflation, slowing economic growth and headwinds to the consumer are likely to constrain revenues. If the U.S. economy goes into recession, profit growth would likely contract, weighing on stocks.
In addition, unusually low equity volatility in 2023 could be difficult to sustain in 2024. The VIX was at 16.8 on average this year, compared to 19.5 over the last 15 years, while interest rate volatility has been elevated to early pandemic levels since the Fed began raising rates. If the U.S. economy falters, interest rate volatility could pass the baton to equities.
Finally, on valuations, valuation dispersion deepened this year, with the top 10 stocks 38% more expensive relative to 25-year averages vs. 14% for the rest of the S&P 500. The S&P 500 overall is about 17% expensive; however, valuations since the Great Financial Crisis have been unencumbered by high rates. Looking at forward P/E ratios over the last 25 years, today’s real interest rate implies that stocks are 30% overvalued. We don’t expect a massive imminent correction while profits are still growing, but valuations may need to reset over time in a higher-for-longer rate environment.
Therefore, from an allocation perspective, we continue to favor quality exhibited in large caps. Small caps have seen a significant valuation reset, but are levered to domestic growth, which could slow. Furthermore, margin pressures could be particularly acute even if input and wage costs are slowing, as 38% of outstanding debt for small caps is floating rate, raising concerns that higher rates could result in more immediate pressure. Within large caps, it’s less about growth vs. value, as we have seen significant divergence even within sectors and industries, and more about stock selection, gearing toward companies with resilient profits, solid balance sheets and favorable relative valuations (Exhibit 1).