With the inflationary threat widely thought to have been defeated, stock markets have enjoyed a broad-based rally fuelled by hopes that central banks will soon cut interest rates. This reflects investors’ increasing optimism in the likelihood of a soft economic landing, in which economic output continues to grow apace while inflation subsides. This is an historically rare pairing; the two normally move in the same direction. Furthermore, periods of falling inflation have historically gone hand-in-hand with thinner corporate profit margins and slower earnings growth. This presents a challenge to market expectations which require earnings growth to accelerate from near zero to a healthy double-digit pace – even as inflation eases back to target.
These considerations, in our view, leave the US equity market in a vulnerable position. Earnings forecasts appear ambitious, and valuations are heady – even if the soft landing comes to pass. Though we continue to have concerns over the macroeconomic outlook, this set-up leads us to believe that a recession is not a prerequisite for equity market returns to disappoint, particularly relative to the 5% yields currently available from high quality bonds. We therefore continue to recommend caution, even – or perhaps especially – as equity markets continue to rise.
The Macroeconomic Outlook
We have for some time expected one of the most aggressive monetary hiking cycles on record to tip developed market economies into recession. While acknowledging ‘long and variable lags’, we have been surprised by the resilience of the global economy, and that of the US in particular. A strong labour market and excess savings have supported households through the cost of living crisis and, with wages now rising more quickly than prices, a resumption in normal service from the all-powerful US consumer is expected. Markets are presuming that this will be sufficient to stave off the threat of recession, but moderate enough not to stoke inflationary flames, leaving central banks free to cut interest rates.
We continue to doubt this narrative. As we have previously argued, soft landings are historically rare – and for good reason: without either fiscal or monetary policy constraining economic growth, there are few viable ways to force inflation to fall back to target. Economic growth implies rising demand – and when, as now, the economy is already operating at full capacity, additional demand is inflationary. Higher interest rates bear down on inflation only by bearing down on demand, and hence growth. This coarseness of monetary policy is ill-equipped to achieve the delicate balance between growth and inflation required of a soft landing.
Thus far, high interest rates appear to have made little impression on growth. That is because they are yet to fully work their way into the economy – but this is now changing. The first three weeks of 2024 saw a record $153bn of investment grade debt issuance as companies rushed to take advantage of the sharp decline in yields over the last two months of 2023. Reacting to the same stimulus, issuance has also been high in government, high yield and emerging bond markets – there have even been nascent signs of life in the frozen US housing market. Yet yields are only back to where they were a year ago, at which point the Federal Reserve had already implemented an eye-watering 4¼% of rate hikes (that is, four-fifths of the trough-to-peak total). The borrowers rushing to issue debt might have avoided the very worst of the interest rate pain, but they must now accommodate meaningfully higher interest costs nonetheless.
Meanwhile, outstanding credit card debt has surpassed $1tr – up more than 14% over the past year – while the use of ‘buy now pay later’ facilities expanded 40% year-on-year to late 2023. Worryingly, delinquency rates (which measure the proportion of consumers falling behind on their debt payments) are already back to pre-pandemic levels and continue to rise. In the corporate sector, some 40% of the Russell 2000 index of US smaller companies is unprofitable. These are sobering statistics in the context of an economy operating at full employment, enjoying above-trend growth and which is still only part-way through the process of absorbing higher interest rates. We believe they are a legacy of the cheap and plentiful credit of the post-financial crisis period, which encouraged the proliferation of consumer borrowing and business models that cannot stand up to the rigours of positive real interest rates. The longer real rates stay above zero, the more likely the moment of reckoning.
The path to a soft landing is extremely narrow. While it is possible – through skill or by luck – that the Federal Reserve could lead the US economy safely along it, we think it more likely that the delicate balance can only be maintained temporarily. Lean a little too far one way and interest rates bear down too heavily on growth, tip a fraction in the other direction and robust demand opens the door to a second round of inflation and rate hikes.
The Market Outlook
Following the ‘everything rally’ in the last two months of 2023, equities – especially in the US – are priced in expectation of a pain-free resolution to the soft landing paradox that demands strong growth alongside low inflation and falling interest rates. While a recession would certainly settle this dilemma decisively, we do not believe it is required for equity markets to disappoint this year.
While an economist’s definition of a soft landing has economic growth holding firm while inflation subsides, investors tend to focus on the growth of corporate earnings. Intuitively, economic growth and company earnings are closely linked, but there are some nuances to the relationship that are perhaps less obvious. The connection between inflation, profit margins and earnings is of particular interest at this juncture.
As the last couple of years have made clear, inflation can make life uncomfortable for consumers: when prices are rising, each pound of expenditure buys fewer goods. In this environment, we might expect companies to reduce profit margins in the hope that prices a little lower than they might otherwise have been will help support demand. In practice, however, companies typically use the cover of inflation to increase profit margins, using price rises to offset any shortfall in demand and thereby delivering positive earnings growth. Conversely, periods of disinflation (in which inflation falls without turning negative) have historically gone hand-in-hand with thinner profit margins and slower earnings growth.
This experience has once again played out over the post-pandemic cycle. As inflation rose, profit margins were expanded, and earnings growth was strong. Subsequently, as inflation has eased, margins have fallen and earnings growth has disappeared.
Remember, the soft landing consensus requires economic growth to continue, allowing companies to grow profits even while inflation fades. Indeed, consensus forecasts for the S&P 500 currently point to 12% earnings growth in 2024 and 13% growth in 2025 – ambitious targets at almost any point in the cycle. However, as the chart below shows, earnings growth seldom picks up when inflation is falling, never mind accelerates to 12% from a standing start.
In short, we struggle to envisage a scenario in which corporate earnings can grow by 25% in the next two years while inflationary pressures are sufficiently muted to allow the Fed to cut rates by 1½% in the space of nine months – all of which the consensus demands.
Arguably, a disappointment on earnings can be withstood if valuations are reasonable. However, a range of measures indicate that this is not the case. While valuations appear most extreme among the largest US companies, particularly the so-called “Magnificent Seven” of Amazon, Apple, Alphabet, Meta, Microsoft, Nvidia and Tesla, the issue is not confined to these names, nor to the technology sector as a whole: eight of the ten sectors in both the MSCI World and S&P 500 indices are trading above their long-term average valuations. Following the sharp rally over the past couple of months, the forward price earnings multiple for the US stock market (based on expected 2024 earnings) is 19.9x. This is expensive: indeed, it has only been higher 11% of the time since 1985. A halving of 2024 growth forecasts would drive the multiple up to 21.4x, a value only surpassed at the height of the tech bubble and, briefly, in the immediate post-pandemic euphoria.
Conclusion
Hopes of imminent rate cuts have largely banished fears of recession from the financial headlines and the mood music in markets has been decidedly upbeat. Unfortunately, we think the optimism is misplaced. The combination of wishful earnings forecasts and lofty valuations is similar – if perhaps less extreme – to the conditions that preceded the 2022 market weakness. This leads us to believe that, while we remain wary of the macroeconomic outlook, it need not take a full-blooded recession for equity returns to disappoint.
While the resilience of the US labour market or renewed fiscal stimulus could forestall the growth slowdown we have long expected, neither resolves the paradox at the heart of the soft landing consensus. Inflation and interest rates may fall, or corporate profits may surpass already ambitious expectation, but the combination of the two is, at best, improbable. We therefore continue to recommend caution, even as the siren song of rising equity markets plays on.
