The beginning of the end, or the end of the beginning?
Maintaining cautiously constructive stance amid confusing outlook.
To quote loosely from Winston Churchill, in the fog of war one is not always sure whether they have reached the point where the end of the war is in sight (“the beginning of the end”) or, alternatively, they have a long way to go and have only come through the first phase of it, called “end of the beginning.” As I speak with analysts, strategists and investors around the country, I feel called to summon my inner Churchill. But I come out differently than he did in 1940 Britain following the aerial dogfight over London, won by the Royal Air Force, with most of WWII still ahead of him. Call me lost in the fog of war, but I believe we have now reached the beginning of the end. Not great news for investors but not bad either. Maybe call it mixed. As explained below and previously, the road ahead is likely to remain rocky for the balance of 2023, featuring further earnings downgrades, credit contraction and an ongoing asynchronous recession in various pockets of the global economy. On the good news front, inflationary pressures should ease further still, with the peak most certainly in on rates. Our macro team has simultaneously cut our forward earnings outlook, inflation outlook and interest rate outlook, keeping our expectation for the S&P 500 to trade this year between 3,600 and 4,400 intact. We continue to advise a cautiously constructive stance on stocks and intend to get more positive as inevitable pullbacks ahead afford opportunities.
Let’s review some of the key elements behind our forecast:
- Banks are not out of it. A protracted period of low profitability, not a crisis, is our base case. We continue to be impressed with how well-capitalized and conservatively positioned most of the banking system is. With the scars of 2008-09 still visible to bank managers and regulators alike, a systemic banking crisis ahead seems unlikely. Prior to their issues, many of us saw Silicon Valley Bank (SVB) and Signature Bank as outliers to be avoided, and that view so far has proven correct. On the other hand, the banking system in general and regional banks in particular have significant exposures on their balance sheets to commercial real estate (CRE). For sure, CRE has been hard hit by the double whammy of rising capitalization rates, due to the Fed hikes, and rising default rates, due to the impact of post-Covid stay-at-home work arrangements that seem to have reduced demand for the office component of CRE, particularly Class B and C properties in city centers. However, unlike the “liar loans” and other shenanigans underlying the massive residential mortgage loan crisis of 2008, CRE loans are neither homogenous nor uniform, are not actively market traded and therefore don’t “come due” (or get marked to current market value) all at once, and in most cases are well underwritten with reasonably conservative loan-to-value ratios protecting the lenders. By the estimates we’ve seen, assuming a continuation of today’s weak office market fundamentals and high bond yields, banks’ CRE losses in today’s weak market conditions are probably $40-$60 billion; a big number, but less than 3% of the total capital base of the U.S. banking system. For sure, these losses are concentrated in the aforementioned regional banks. Even so, the losses are likely to be staggered over several years, or perhaps never fully realized as the office market perhaps improves in the out years. Our banking analysts are cutting their forward earnings numbers, and this is the primary reason we are reducing our 2023 and 2024 S&P 500 earnings by $10 each year to $190 and $230, respectively. But most bank stocks have already dropped far more than these earnings downgrades would imply. Our guess is if we get through the rest of the year without another big bank bust, the worst may have already passed.
- The recession in Tech isn’t over. But the light at the end of the tunnel is in sight. If the banking sector is heading into its share of the rocky landing, it is possible that the tech sector is getting closer to coming out of its. A recent bevy of chip company reports suggests that inventories are beginning to clear, and the onset of artificial intelligence investing could clear the rest soon. Earnings downgrades, which began in earnest in Q3 2022, most likely have one last big drop to come in this quarter’s reporting season. But tech stocks tend to bottom ahead of their final earnings down-leg, and that may explain the recent apparent bottoming we are seeing in many of these stocks. Likewise, the layoff announcements that started last fall among these companies have recently accelerated and may similarly be closing in on a peak. And while the halcyon days of 30-40% revenue growth experienced during Covid may never return, if the overall technology industry can simply resume growing at a 10-15% pace by later this year, that would be a big plus.
- Commercial real estate likely will be a slow motion trainwreck over the next three years. If our outlook at the CRE market is right (see above), while a crisis may be avoided, the prospect for new builds and new activity seems low anytime in the next three to four years. So, this sector of the economy seems likely to be in a recession for a long time, depressing overall growth. And residential housing construction is still stalled due to excessively high mortgage rates, but that could ease if rates begin dropping.
- Inflation should continue to ease, helping the Fed do the same. Even as this week’s weak jobs numbers have economists lowering their GDP numbers (toward our below-consensus growth forecasts), there clearly is something to cheer: wage inflation is likely to drop similarly amid all the rising reports of layoffs and banking problems. We’ve felt the bank credit contraction that resulted from the SVB failure was worth the equivalent of at least another 25-50 basis points of hikes. And with the supply chain issues that were plaguing us a year ago now largely resolved, we’ve lowered our core PCE inflation estimates for 2023 and 2024 to slightly below the Fed’s own current forecasts of 3.6% and 2.6%, respectively, and have a downward bias based upon tighter lending standards emanating from the banking crisis and the slowdown suggested by this week’s employment data. Said differently, whether the Fed knows it or not, our guess is its work on the inflation front is now largely done. We’re increasingly optimistic that today’s 5% target rate already is the peak, and that some modest cuts could be forthcoming by later this year. Even though we don’t think yields are likely to come back to the ultra-low, rocket-fuel pandemic levels, just the prospect of longer-term Treasuries settling in somewhere in the 2.5%-3.5% range, which we now see as likely, would be good for stocks.
Adding all this up, while we think it’s too early to declare victory or the end of the rocky landing, we do think it’s time to declare the beginning of the end of the rocky landing. We’re staying constructive on stocks and remain poised to add further in the inevitable pullbacks ahead. With a tough earnings season now upon us, and the wobbly banking sector first up on the list, opportunities for dip buyers may be coming sooner rather than later. If so, we’re ready.