By Joseph Amato, chief investment officer – equities at Neuberger Berman
As we adopt a more cautious view toward equity markets over the next 12 – 18 months, an increasingly problematic mix of high inflation, rising interest rates and softening economic growth could persuade investors to go from buying the dips to fading the rallies.
Cautious, however, doesn’t mean bearish. Both sets of views are nuanced – noting, in particular, that the current economic robustness provides a meaningful buffer to absorb a slowdown in activity, high inflation and tighter monetary policy.
Those fundamental underpinnings are worth bearing in mind as we enter the first-quarter earnings season. While we think that elevated volatility is likely to persist, a substantial decline in equity markets remains unlikely as long as earnings hold up and recession is avoided.
Growth Versus Inflation
Current market consensus is for approximately 5% first-quarter earnings growth, year-over-year, for the S&P 500 Index.
Based on past patterns, reported earnings growth is likely to be modestly higher than that, which we would view as an important reminder that the economy is still recovering from the impact of the COVID-19 pandemic. For all of 2022, analysts’ S&P 500 earnings forecasts are still holding up in the high single digits.
Might inflation start to pressure margins and bite into those earnings? We are hearing more and more management teams talking about rising costs associated with tight labour markets and ongoing COVID-19 and supply-chain disruption but, so far, they have generally been able to increase prices to at last partially offset these higher costs.
We can see a similar balance of forces at the level of the broad economy: At 8.5%, the US year-over-year inflation rate that came out last week was the highest since 1981; but initial jobless benefit claims have declined to levels unseen since the late 1960s. Consumers may be feeling the squeeze, but they continue to have job opportunities to choose from and confidence to spend.
How serious is the threat of recession?
In our view, at least on a 12-month horizon, we think the risk remains modest in the US, given the underlying robustness of the economy.
We think the biggest risk is from the impact of aggressive monetary policy response to contain inflation. A number of US Federal Reserve policymakers have said that, to tame prices, rates need to be neutral or above by the end of this year.
Tighter monetary policy could bring global Purchasing Managers’ Indices (PMIs) back down to the level of a moderate industrial recession, but we do not anticipate negative US economic growth. Whilst the interest rate market appears to reflect reassurance about the central bank’s ability to manage inflation without inflicting excessive collateral damage on the economy.
The growth and inflation picture may be more challenging elsewhere.
Europe had looked to be at less risk of rising prices due to its looser labour market, but is now highly exposed through its Russian and Ukrainian fossil fuel and food imports. The current consensus expectation for the STOXX Europe 600 Index has earnings growth in 2022 at 10%, and 6.5% in 2023 – however, as we are already seeing net-earnings revisions turn negative, we think those 2022 and 2023 forecasts are likely to be close to zero soon. China also looks more vulnerable than it did a few months ago, due to renewed COVID-19 disruption. This is one reason why we now favour US equities.
Overall, we have little doubt that markets face a challenging period of stubborn inflation combined with slowing growth, likely leading to persistent volatility.
That makes a case for higher-quality, lower-beta, income-oriented equity exposures; for larger companies over smaller; and US over non-US markets.
But the economy is still growing, consumers are still spending, and many businesses are still making profits. Investors may want to position portfolios to mitigate the volatility – but we still believe equities have the potential to be positive this year.