The other side of zero
Modestly more constructive on stocks as rocky landing approaches final phase.
As the “Rocky Landing” scenario enters its second year, we think it is time to begin getting modestly more constructive on equities. For sure, the all-important inflation and GDP data in the quarters ahead most likely will bounce around, giving both bulls and bears something to cheer for, alternately. And the Fed, facing an inflationary supply-constrained economy, is likely to hike further before shifting to a “hold ’em high” stance, lest it repeat the mistakes of its 1970s’ forebears. Further, squeezed between rising costs and increasingly strained consumers and corporate customers, the stock market’s publicly traded companies almost certainly will report lower earnings in the quarters ahead, perhaps as low as our $200 target for this year. None of this is good.
Still, as rising-wage pressures start to ease, and time moves on giving companies the opportunity to adjust cost structures, the odds of eventually pulling through the rocky months ahead are surely rising and will rise higher with each passing quarter. And as 2023 dribbles along, investors will begin for sure to focus on 2024, where a better environment for stocks probably awaits. At Federated Hermes, our own outlook for 2024 earnings is substantially better than 2023, perhaps as high as $240 on the S&P 500. And one way or the other, inflationary pressures should ease by then, stabilizing interest rates and stock valuations. By year-end 2023, forward-looking investors are likely, in our view, to value stocks at something like 18x year-ahead earnings, which would value the S&P closer to 4,400. With this in mind, we’ve expanded our potential 2023 range for stocks, maintaining our low-end possibility of 3,400 at some point during the year but raising our year-end potential to 4,400 from 3,900.
Given all of the above, Federated Hermes’ asset allocation team elected earlier this week to shift from a modestly bearish view on stocks to a modestly positive one, i.e., from a 1% underweight versus neutral to a 1% overweight. We think this acknowledges that while the risks ahead for choppy markets remain high, on a one-year view stocks probably have modest upside relative to all other asset classes. We implemented this change entirely by adding to international markets (both developed and emerging), where valuations are low, a weakening dollar is providing tailwinds and relatively attractive and economies led by a reopening China are already beginning to emerge from their own rocky landing. Even as the war in Ukraine drags on, its impact on the continent appears to be waning. Indeed, Europe has averted an energy crisis, for now, amid a much warmer-than-expected winter and large stockpiles of natural gas. Eurozone manufacturing and services also appear to have bottomed, and its consumers continue to spend. On the U.S. side, we remain overweight older economy value stocks and underweight growth. We also remain overweight cash and underweight bonds.
Let’s unpack the key points of why we’ve made this shift:
- Inflationary pressures remain high but may be easing. Virtually every measure of prices—headline and core CPI and PCE, ISM prices and even specialized Cleveland and Dallas Fed gauges that home in on underlying pressures—have come off highs. A lot of this is being driven by moderating goods prices, but more stubborn services are starting to show signs of breaking, too, particularly the all-important housing component, with market rents that are major factor in core CPI and PCE start to roll over. Also, wage growth has begun to trend down off extremely elevated levels, though labor shortages and minimum wage increases that kicked with the new year, particularly in services, are likely to keep wages “sticky” for some time.
- The Fed remains restrictive but is nearing the end of its hiking cycle. After 425 basis points of policy rate increases in 2022, policymakers are signaling they are almost done (but in no rush to ease), with December’s projections indicating another 75 basis points or so are likely in this year’s first half. That would push the terminal rate well above 5%, where the Fed’s dot plot and rhetoric suggest it will hold for the year. The bond market isn’t so sure as futures are pricing modest rate cuts by early fall. Either way, the worst appears to be over on the monetary policy front.
- Economy is weathering the rocky landing and a severe recession and/or financial crisis is increasingly unlikely. We and others were surprised by the strength of the economy in the back of last year. On the other hand, recent readings on the manufacturing and services economy reflect a sharp deceleration, consumer spending has been moderating for months as households plow through excess Covid-related savings (now estimated at around $1.2 trillion, roughly half its year-ago levels) and housing is in a deep funk. The offset: the labor market. It’s difficult to envision a deep contraction when job openings are running more than 4 million above the number of unemployed (the exact opposite of the situation in pre-Covid 2019), corporate and household balance sheets remain in pretty good albeit eroding shape and eruptions such as crypto’s collapse aren’t spilling over into the broader markets.
- Corporate earnings are under pressure but should eventually stabilize, particularly in the “old economy” sectors. This is the proverbial shoe that we still expect to drop as companies are forced to account for moderating demand and higher input prices. They’ve been able to hold up fairly well, in large part on their nominal sales gains early in the inflation cycle even as much of their operating costs remained at fixed at lower levels. That’s no longer the case. Earnings growth has been slowing and we think EPS could hit $200 this year, the lower end of Wall Street forecasts and down from our estimated $225 for 2022, as margins get squeezed. However, off these lower levels, as we approach the end of 2023, investors will probably be able to bank on an earnings recovery in the years ahead. Markets should begin discounting this recovery through the course of this year.
- A reopening China provides a global economic boost, particularly to Europe and emerging markets. With President Xi having spent much of last year flexing his policy chops to secure an unprecedented third term at October’s 20th National Congress, China is now focused on propping up an economy that, except for Covid-impacted 2020, grew at its slowest pace in four decades in 2022. In the past few months, zero-Covid lockdowns have been lifted, fiscal stimulus and monetary easing have been stepped up, and a lighter regulatory touch on private enterprise has been adopted to jumpstart growth. With high household savings and fading dollar strength also providing tailwinds, stronger growth in China seems inevitable. The only downside to this reflation is the potential to drive energy prices higher (OPEC+ already is wedded to a floor), an outcome that could make the inflation fight tougher.
So, while we think it’s premature for sure to declare the “all clear” signal for investors, we do think it’s time to begin getting a little more constructive. While volatility remains likely and an S&P dip toward lower levels is not out of the question, the outlook for 2024, at least, has grown less uncertain and better at the same time. Bear markets can be a function of magnitude and time, and more than a year into this one, we’ve had a taste of both. Therefore, we are suggesting investors consider shifting from “sell the rally” mode to a “buy the dip” mode, and should we get a move lower in stocks as the rocky landing hits another bump or two, we anticipate adding further to equities. In the meantime, we have shifted from a 1% underweight in stocks to a 1% overweight. If and when we get a retest lower, we’ll buy more. We’re beginning to see the other side of the valley and with this, it’s also time to get to the other side of zero.