CIO thinks the Fed will likely need to keep monetary policy restrictive, forestalling any reacceleration in economic growth that could reignite inflation. (ddp)

Still, markets appear to read it as insufficient to deter a Federal Reserve rate hike in May. US 2-year Treasury yields were up 12 basis points on the day, the US dollar index partially trimmed its weekly losses to 0.5%, and money markets firmed expectations for a 25bps hike.

So far, early results and guidance from companies whose fiscal quarter ended in February have been encouraging, beating earnings estimates by 6% compared with 3% in recent quarters, despite concerns that the recent tightening in credit conditions could weigh on corporate profits. Top US lender JPMorgan on Friday beat consensus first-quarter earnings estimates, helping to lift the S&P financials subindex by 1%.

Early results appear in line with our expectations that 1Q S&P 500 EPS may be surprisingly resilient: The impact from credit tightening should take time to show up in corporate fundamentals, consumer spending has remained supported by a still-healthy jobs market and excess household savings, and supply chains have also continued to improve, helping to lower costs. Finally, the “bar” for the earnings season seems low. The 1Q23 bottom-up estimate for the S&P 500 has fallen by 6.5% over the last three months.

But while the upcoming earnings season may not weigh on market sentiment, we still see reasons for investors to remain cautious on US equities this year.

Tighter lending standards look set to weigh on earnings. Credit conditions were already tightening even before the banking sector turmoil in March. The January 2023 Senior Loan Officer Opinion Survey (SLOOS) showed that a net 45% of banks tightened lending standards for large- and medium-sized firms. The only other times when credit was this tight were during the COVID-19 pandemic, the global financial crisis, and the dotcom bust. We consider bank lending to be the lifeline of the economy. If credit standards remain this tight or get more restrictive, profit growth should likely continue to come under pressure.

Inflation is still too far above target for the Fed to consider rate cuts for now. Although inflation is cooling, it remains too high, in our view. We think the Fed has more work to do to get inflation back down to its 2%target. The labor market is still reasonably strong. Historically, the Fed has not cut rates when unemployment has been this low. As a result, we think the Fed will likely need to keep monetary policy restrictive, forestalling any reacceleration in economic growth that could reignite inflation.

Full year consensus earnings estimates are too high, and valuations are still expensive. We think that consensus expectations for a reacceleration in S&P 500 earnings growth and margins are unlikely. We expect S&P 500 EPS to contract 4.5% in 2023 before expanding 9.5% in 2024, which are about 5% below bottom-up consensus estimates. Also, even if the S&P 500 constituents beat earnings by 3–5%, that would still translate into a decline of 1–3% relative to the same period last year.

Furthermore, valuations are expensive. The S&P 500 forward P/E of 18x is still near its highest in a year and above pre-pandemic levels. Historically, these levels would be consistent with robust consensus earnings growth expectations of 14% on average (compared to the current 4%) or 10-year Treasury yields less than 2% (vs. the current 3.4%). This suggests that valuations may be too optimistic.

So, we remain least preferred on US equities and recommend investors diversify beyond the US and growth stocks. We are most preferred on emerging market equities, where we expect the MSCI EM index to deliver low-teens percentage returns this year, thanks to strong earnings growth, China’s economic recovery, and relatively cheap valuations. Within emerging markets, two of our preferred areas are Chinese equities and Asian semiconductors.

Main contributors - Mark Haefele, David Lefkowitz, Nadia Lovell, Matthew Tormey, Patricia Lui, Jon Gordon

Content is a product of the Chief Investment Office (CIO).

Original report - US earnings have yet to reflect underlying headwinds, 17 April 2023.