Global equity market performance was disappointing in the second quarter, to put it mildly. U.S. equities, as measured by the S&P 500 Index, decreased 16% in the quarter, including dividends. On a year-to-date basis, the stock market has declined by 20%, officially bringing it into bear market territory. Non-U.S. equities, as measured by MSCI’s All Country Worldwide Ex-U.S. benchmark, fell 14% in the second quarter including dividends, representing a 19% year-to-date decline. Numerous factors pressured stocks during the quarter. First and foremost, increasingly aggressive monetary actions by the Federal Reserve in response to persistently high inflation are leading investors to believe the U.S. economy is headed for a recession. The Fed’s motivation behind accelerating the pace of raising short-term interest rates is to slow economic growth in order to reduce demand for goods and services, thereby
relieving pricing pressures. Doing so without sending economic growth into negative territory (i.e. recession) is extremely difficult. Investors are skeptical, and risk assets, such as stocks, are suffering.
The impacts of Fed actions are far-reaching. Rising short-term rates are driving longer-term rates higher, which raises borrowing costs for consumers and businesses. Housing activity is slowing, especially when it comes to refinancing and new loan applications. A key problem with the Fed’s actions is that they take a long time to impact inflation, so we will
not know if the Fed has gone too far for quite some time. By then, it could be too late to keep the economy out of a recession. The bottom line for the stock market and why it was weak in the second quarter, as we have highlighted in previous Economic & Market Commentaries, is that stock prices follow earnings expectations. Inflation, rising interest rates, geopolitical turmoil, supply chain issues, and other current pressures – each, and in combination with each other – present possible headwinds to corporate profit growth moving forward. That is the fear, and that is why investors are selling. Despite global stock market weakness and the numerous headwinds facing global economies right now, forward estimates for corporate profit growth, as measured by S&P 500 Index earnings, remain resilient. In fact, estimates for 2022 and 2023 continue to rise, although numbers for 2024 are down modestly. It is quite possible the aforementioned macroeconomic headwinds simply have yet to impact earnings estimates, though this phenomenon is somewhat surprising as we would have expected economists and analysts alike to be reducing their estimates by now.
With 2022 earnings estimates increasing in the mid-single digits thus far this year, and the S&P 500 Index having declined 20%, valuations have been the key driver of stock weakness to-date. In fact, the aggregate forward P/E multiple on the S&P 500 has fallen from 21.5x at the beginning of the year to 16x at the end of June. This compares to a 25-year average of nearly 17x. In essence, investors are voting with their feet. They are not waiting for numbers to come down before they sell, which is pressuring stock valuations. Of course, rising interest rates should also pressure valuation multiples (i.e. higher interest/discount rates reduce present values and also raise the relative attractiveness of other asset classes like cash), but the magnitude of the valuation contraction we have seen (as depicted in the chart below) either portends significant pain ahead, or the market has preemptively overshot to the downside.
CHART
As we look to the second half of 2022 and beyond, we see one of two possible scenarios playing out for the stock market. The first scenario is that forward earnings estimates see a meaningful decline. Stock prices can be a leading indicator of future economic activity at times, and the market certainly seems to be predicting further declines ahead. In this scenario, the magnitude of the earnings decline would determine where stocks go from here. When we think of the downside scenario for stocks, a roughly 10% earnings decline from $228 to $205 earnings per share for the S&P 500 seems appropriately conservative. Applying a 16-18x P/E multiple (which may be overly punitive given current valuations are already discounting lower earnings to some extent) on $205 EPS implies a 3,280-3,690 range for the S&P 500 Index. This range represents 5-15% downside from current levels. (Note: we are not making a prediction here, but rather conveying our thoughts on what a stress-tested downside scenario is for the S&P 500 Index in the event earnings are to meaningfully contract.)
The second scenario we think could be possible from here is that earnings estimates actually prove to be more resilient than many fear. First, consumer spending is more than 2/3rds of U.S. GDP, and the U.S. consumer remains in very good shape. Employment is strong and wages are rising at the fastest rate in years. Consumer balance sheets remain healthy as savings are still high from COVID stimulus payments. Beyond consumer spending, companies across every sector of the economy are adopting increasingly cautious approaches to capital spending and expenses, which should help buffer pressures on profit margins due to cost inflation.
Under these circumstances, if current earnings estimates are in the ballpark, then the market may have already discounted this scenario, in which case stock valuations look reasonable, if not compelling. Either way, the near-term outlook for equities is unclear. We would not be surprised to see some pressure on forward earnings estimates given the environment, but based on the signals we are currently seeing, significant pressure on earnings (i.e. 10% decline) appears to be less likely.
Bottom line: Howland Capital’s approach remains consistent. We aim to ensure clients have enough cash to weather the current market downturn, and to stay appropriately invested for the long-term. History repeats itself, and if history is any guide and in light of today’s issues, the market will recover and Howland Capital’s clients stand to benefit from further equity market appreciation over time.
