Last month we argued that the macroeconomic environment for government bonds was turning more favourable and that an end to this year’s sharp sell-off was in sight (see our commentary of October 2022). In recent weeks, benchmark 10-year government bond yields in the US and UK have fallen back (i.e., bond prices have risen, as prices move inversely with yields) as market expectations for how high central banks will ultimately need to raise interest rates have been pared back.
In the UK, the prospect of tighter fiscal policy, along with dovish guidance from the Bank of England and economic data showing the economy sliding towards recession have seen market expectations for the terminal rate (i.e., the peak for the central bank’s policy interest rate in the current cycle) fall from over 6% in the wake of the ill-fated mini-budget to 4.6% currently1.
In the US, lower-than-expected inflation data for October has also caused investors to revise down the degree of tightening expected from the Federal Reserve (the Fed). With evidence mounting that US inflation is now on course to head lower during the coming months, markets now see the Fed’s policy rate topping out at 4.8% down from a peak of just over 5% earlier this month2.
One can never be certain, but these developments increase confidence in the view that the worst of the sell-off in government bond markets is behind us and that this year’s rise in bond yields provides the set-up for a better total return performance from the asset class in 2023.
Equity valuations and bond yields
In turn, trends in fixed income markets have knock-on ramifications for stock markets, and a topping out in interest rate expectations and bond yields is good news for equity market valuations. This year’s relentless upward revisions to US interest rate expectations and subsequent rise in bond yields has been a key driver of the sell-off in US and global equity markets. This is because under the discounted cash flow model, higher bond yields reduce the present value of future corporate profit streams. Of course, many factors drive equity prices, including profits expectations and investor sentiment, but other things being equal, higher bond yields tend to put downward pressure on stock market valuations.
As bond yields have risen this year, key gauges of equity market valuation such as the forward price to earnings ratio (defined as the price of an individual equity or equity market divided by the consensus earnings per share forecast for the next 12 months for that company or market) have fallen back markedly. For example, the rise in the yield on the 10-year US Treasury bond from 1.5% at the start of the year to 4.1% by the end of October coincided with the forward p/e ratio of the main US equity index of 500 leading shares dropping from around 22 to close to 16 over the same time period3.
If bond yields are topping out because expectations for interest rate hikes are pared back, then one source of downward pressure on p/e ratios should abate. Indeed, if yields fall back further, this would be supportive of an expansion in valuation multiples, other things being equal.
However, as noted earlier, equity prices are not solely determined by interest rates and bond yields; earnings matter too. And there is evidence to suggest that profits are now coming under pressure following the bumper gains seen in 2021, when reopening economies boosted revenues and strong corporate pricing power enabled companies to expand profit margins. According to Factset, third quarter profits for the 500 largest listed companies in the US rose 2.2% from the same period a year earlier – the lowest rate of annual growth since Q3 of 20204.
Moreover, much of this increase was due to the sharp rise in earnings of companies in the energy sector, which have benefitted from elevated oil and gas prices resulting from the war in Ukraine. If the energy sector is excluded, earnings actually fell 5.1% y/y - the second consecutive quarterly decline of ex-energy profits – as rising input costs, slowing global growth and US dollar strength (see our commentary of September) took their toll.
Recession risks
Looking forward, there is a clear risk that consensus expectations for profits growth is too optimistic. It should be remembered that one of the factors underpinning the more favourable outlook for government bonds is the increased likelihood that the US and European economies slip into recession during the next 12 months.
Several leading indicators suggest that the odds of recession are rising. The global composite PMI, a measure of activity in the manufacturing and services sectors, fell below the 50 level which separates expansion and contraction in October, with business optimism falling to a 28-month low5. In addition, the recent inversion of the yield curve, as measured by the gap between the yield on the 10-year US treasury bond and that on 3-month paper6, suggests a high probability of recession during the next 12 months or so (see our commentary of April 2022).
Consensus profits forecasts for 2023 do not appear to be pricing in a recession. To be sure, earnings forecasts for next year have been revised down in recent months, but equity analysts still expect US earnings to rise 4.3% in 2023 after an increase of 7.9% in 20227.
Some observers argue that because inflation is elevated, nominal GDP growth during any forthcoming recession will be higher than that typically seen during recent downturns, thereby providing support to corporate revenues and earnings. Moreover, with household balance sheets in pretty good shape, any recession could be relatively mild compared with those seen during the great financial crisis and the pandemic (see our commentary of July 2022).
Even so, it would be unusual if profits keep expanding against the backdrop of a contraction in real GDP. Corporate earnings have fallen in each of the last 10 US recessions, with the average peak to trough decline in earnings per share around 30%8. As a result, it seems likely that consensus earnings forecasts will be revised down further during the coming months.
Margin squeeze
Aside from the cyclical impact of weaker economic activity, other factors are making the outlook for corporate earnings more challenging.
Labour shortages in the wake of the pandemic are resulting in higher rates of wage growth (6.4% y/y in October according to the Atlanta Fed9), which in turn is putting pressure on profit margins. Although a cooling in the labour market should ultimately see cyclical wage pressures ease back, workers might be seeing a structural improvement in their bargaining power that allows them to take a greater share of national income at the expense of corporate profits. A move towards deglobalization and reshoring might imply less competition from lower cost overseas workers.
Moreover, after decades of decline, there is tentative evidence that rates of union membership are on the rise as workers become increasingly willing to take industrial action in support of better remuneration and working conditions10. This, in part, has been the result of the pro-union stance of President Joe Biden, whose administration has sought to promote union membership and workers’ rights11.
A recent study by the Federal Reserve also highlighted the role of lower tax rates and falling debt servicing costs in driving profits growth in recent years, and suggested that these factors are likely to be less supportive going forward. According to the report’s calculations, a reduction in interest and tax expenses was responsible for a full one-third of all profit growth for the largest listed non-financial US corporations during the last two decades12.
Looking forward, the tailwind from lower debt servicing costs is likely to become a headwind, given the sharp rise in interest rates and bond yields seen this year. Although an easing in price pressures has raised hopes that the Fed will not have to hike rates above 5% in the current tightening cycle, the monetary authorities will be wary of cutting borrowing costs too quickly for fear of reigniting inflation. In the absence of a deep recession or a bout of severe financial instability, a return to near-zero interest rates is unlikely to happen anytime soon. As a consequence, companies refinancing their debts are likely to face higher interest costs, which will dent profitability.
Higher taxes
A rising tax burden is also likely to act as a drag on corporate profits going forward. The reduction in the statutory corporate tax rate from 35% to 21% introduced as part of the Tax Cuts and Jobs Act of 2017 provided a boost to after-tax profits. However, the Biden administration is now raising taxes on businesses. JP Morgan estimate that measures included in the recently passed Inflation Reduction Act – notably the 15% corporate minimum tax and the 1% tax on share buybacks - will subtract 3% from the earnings of the 500 largest listed US companies in 202313. Given elevated levels of public debt and pressures on government spending (from an ageing population, climate change etc.), there is a risk that taxes will have to rise further over the longer term.
In this article, we have focused on some of the factors that are likely to influence corporate profits in the US (given the outsized influence of the world’s largest economy on global financial markets), but other developed market economies clearly face similar challenges. In the UK, for example, the number of listed companies issuing profit warnings during the third quarter jumped to its highest level since the 2007-09 global financial crisis, as costs increased and demand slowed14.
All of this does not necessarily mean that equity markets will fall back. An improvement in sentiment – potentially resulting from a further moderation in inflation and interest rate expectations - could prompt investors to pay a higher multiple for expected earnings, causing the forward price to earnings ratio to rise.
Moreover, in terms of seasonal trends, equity markets tend to do relatively well over the winter months15. In addition, the US electoral cycle is also supportive at the current juncture; over the past 70 years, US large cap equities have always delivered positive gains during the year following the US mid-term elections, posting an average return of 15%16. However, with consensus profits expectations looking too optimistic given the economic outlook, further downgrades represent a clear risk for equity markets going in to 2023.
15th November 2022
1 https://www.bankofengland.co.uk/statistics/yield-curves
2 https://www.atlantafed.org/cenfis/market-probability-tracker
3 https://www.yardeni.com/pub/sp5peinflby.pdf
4 https://insight.factset.com/ex-energy-sp-500-reporting-a-decline-in-earnings-for-the-2nd-straight-quarter
5 https://www.pmi.spglobal.com/Public/Home/PressRelease/63cee2ed73df4a359c526338f2195068
6 https://fred.stlouisfed.org/series/T10Y3M
7 https://www.yardeni.com/pub/sp500analycons.pdf
8 https://dadavidson.com/News/Perspectives/ArticleID/3582/What-a-Recession-Means-for-Markets
9 https://www.atlantafed.org/chcs/wage-growth-tracker
10 https://www.cnbc.com/2022/05/07/why-is-there-a-union-boom.html
11 https://www.whitehouse.gov/briefing-room/statements-releases/2022/02/07/white-house-task-force-on-worker-organizing-and-empowerment-report/
12 https://www.federalreserve.gov/econres/notes/feds-notes/the-coming-long-run-slowdown-in-corporate-profit-growth-and-stock-returns-20220906.html
13 https://am.jpmorgan.com/us/en/asset-management/adv/insights/market-insights/market-updates/on-the-minds-of-investors/how-will-the-inflation-reduction-act-impact-the-economy/
14 https://www.ft.com/content/b0d68d9a-5d2b-4cfb-91fb-1f365ce5e370
15 https://www.investopedia.com/day-trading/best-time-day-week-month-trade-stocks/
16 https://www.reuters.com/markets/europe/recession-fears-threaten-perfect-track-record-post-midterm-us-stock-gains-2022-10-27/