There are winners and losers. Many companies have been winners, with sales revenues extremely strong and pricing power allowing profit margins to rise.
After the multiple adjustments in equity markets last year, the stability of bond yields since last October has allowed equity prices to benefit from the nominal effect on revenues and earnings. That may change and the macro narrative is negative.
But given the step change higher in nominal GDP growth levels in the past two years, the downside for stocks might be surprisingly limited and short-lived. And there are clear positive long-term growth trends and plenty of money to invest. Another bull market this decade looks highly likely.
Equities up in 2023
Investors and commentators who heavily weigh the macro view in their expectations of market behaviour have got it wrong in 2023 so far. Bond returns are positive and equity returns are healthy. The S&P 500 is up around 7.7 per cent year to date in price terms and the total return from the MSCI World Index is 9.0 per cent.
What is going on? Real US GDP growth was just 1.1 per cent in the first quarter (Q1), credit conditions are tightening, and there have been bank failures. According to surveys — and conversations I have with investors — there is not much positive sentiment towards equities. The outlook is one defined by forecasts of a US recession and slower corporate earnings growth.
Think nominal
I think to understand the performance of equities, we need to think in nominal terms. My comments are limited to the US, but they hold for other markets too. Since Q1 2020, the US economy has expanded by 23 per cent in nominal terms.
In Q1 2023, annualised nominal GDP growth was 5.1 per cent and year-over-year growth was 7.0 per cent. For the last eight quarters, nominal growth has been above its long-term average. Of course, this is due to inflation. The difference between real GDP and nominal GDP growth since Q1 2020 has been a cumulative 16 per cent. That is, of the 23 per cent expansion in the current price value of economic activity in the US, 70 per cent has been due to rising prices.
Economic transactions of all kinds are taking place at a higher dollar value today than they were a year or two ago. But that means higher revenues and wages. For individual economic agents, revenues (income) do not necessarily rise at the same rate as costs (prices). There are winners and losers when inflation is higher.
Revenues up, margins higher
The significance of this for equities is clear. Sales growth, in current dollar terms, has been strong. Over the same period, for the S&P 500 universe of companies, revenue per share has increased by 25 per cent. In an inflationary environment, companies, of course, face higher input costs and pressure for higher wages.
At the same time, they can exploit pricing power. And they have. Profit margins have increased in the last three years. From the worst part of the pandemic, in Q3 2020, profit margins have risen from 9.2 per cent to 12.05 per cent in Q1 2023, according to Bloomberg estimates. They peaked at 14 per cent in Q3 2021. Sales revenues have continued to rise. In the past year, they are up 7.9 per cent.
Earnings growth is now slowing because margins are coming back down under the pressure of rising wages and pressures on revenue growth in sectors like energy and banking, coming after the adjustment to growth in technology.
US earnings season, current estimates suggest earnings per share are going to be down around 4 per cent compared to Q4 2022. Nominal GDP is also slowing. According to consensus forecasts, nominal growth will slow to around 5.0–5.5 per cent this year and 3.5 per cent in 2024. That is quite a downshift from 2022’s 9.0 per cent. It will be hard for sales growth to sustain the near 8 per cent pace of the last year.
The recession narrative
Stocks tend to go down in a recession. Typically, by the time the Federal Reserve (Fed) cuts rates, the economy is already in recession and equities tend to underperform bonds.
This may be the road ahead with the market still pricing in interest rate cuts from the end of this year. Forecasts are for 4 per cent earnings growth for the S&P 500 over the next year. This is not as weak as in previous recessions, but it may reflect the lingering nominal effect (the implication being that sales revenue growth will remain positive and margins will not contract that much, especially if the prognosis is a softish landing). Yet there are reasons from a macro perspective to expect pressure on corporate earnings as economic growth slows.
The 1.1 per cent expansion in real GDP in Q1 suggests that we are within a whisker of a recession. Yet the continued strength in the labour market and in a number of other indicators suggests that a deep correction in the economy is not on the cards.
Long-term positive
I believe that US equities should benefit from a growth premium and that means a higher P/E ratio compared to other markets. There are secular trends that are extremely supportive, which I have mentioned before. The legislative programs of President Joe Biden’s administration to boost investment in the energy and technology sectors are supportive. Shifts in global supply chains are leading to the near shoring of manufacturing (Mexico is benefiting from that) and growth in use of artificial intelligence could boost productivity as well as investment in the computing infrastructure necessary to allow its broader application throughout the economy. If inflation settles and interest rates do not go up much further, the outlook can be positive.
Nominal US GDP will go up still and any adjustment in stock prices that takes the Buffett Indicator lower is likely to be a buying opportunity.
There is a lot of dry powder sitting in money market funds so any combination of lower equity markets and the Fed pivoting (in the next 12 months or so) could pave the way for another favourable market.
Chris Iggo, chief investment officer, AXA Investment Managers
