Equity Insights offers research and perspectives from Putnam's equity team on market trends and opportunities.
This month's author: Shep Perkins, CFA, Chief Investment Officer, Equities
For global equities, we've seen a hopeful start to 2023. Many macroeconomic challenges are still with us, however, and they continue to test the sentiment of investors who fear the next discouraging "surprise." In our view, the biggest surprise for U.S. equities in 2023 will be that, despite bad news, the market will finish higher. The few unexpected positive scenarios are likely to be a catalyst for equity market advances, despite an abundance of competing negative data. Outside the U.S., what's been most surprising and encouraging is the resilience of the western economies, notably Europe. The collapse in energy prices, helped by seasonally warm weather, has taken the edge off inflation too.
"Something has to break" — but a lot has already broken
With the aggressive tightening from central banks, conventional wisdom says "something must break." But let's not forget how much the markets have already endured. Among the 2022 "highlights" were the biggest declines for U.S. equity indexes since 2008, a Nasdaq decline of more than 30%, the collapse of cryptocurrencies, and the most significant housing slowdown in decades. Through most of 2022, the AAII Sentiment Survey was pointed at "fear" or "extreme fear."
Understandably, investors continue to brace for more bad news. But this could be positive for equities because we are now missing the element of surprise. Much of the negative data that comes our way this year will be widely anticipated — especially as it relates to economic slowdowns.
In our view, the biggest surprise in 2023 will be that, despite bad news, the U.S. equity market will finish higher.
Tug-of-war: Easing inflation vs. earnings cuts
Today, we are eyeing two key forces that could make 2023 a volatile year, but hopefully also a positive one. The first is inflation. Rising interest rates have tightened financial conditions and slowed parts of the economy, and there are tangible signs of easing inflationary pressures. But what matters more to the Federal Reserve is wage growth, and employment has been resilient in most sectors. As for a much-anticipated Fed pivot, we expect to first see a slowing of rate hikes, then a pause, and eventually a pivot. Each phase should be well-received by equity markets, as stocks likely won't be "fighting the Fed" like they were in 2022. These conditions are good for stocks and could bring higher price-to-earnings multiples.
The second key force is earnings, which could take a hit from the Fed-induced slowdown in the economy. We've already seen meaningful earnings cuts, and aggregate S&P 500 quarterly estimates have fallen 10%. Estimates for the first half of 2023 have earnings declining slightly year-over-year. These estimates come while the economy is still holding up relatively well. As the economy slows further, likely into recession, the downward trajectory of revisions could continue. However, some important earnings headwinds have now turned into tailwinds, including the decline in the U.S. dollar and the fall in commodity prices.
Why we expect an equity rebound in 2023
Ultimately, 2023 will likely be a positive year for equity markets for several reasons:
- The market is forward looking, and investors are ready for "scary" headlines around layoffs, rising unemployment, and potential bankruptcies of well-known companies.
- Any good news will have a greater impact than bad news. P/E multiples should start to expand when the market senses that easier conditions are emerging.
- The yield on the 10-year Treasury stopped increasing, and even retreated, last year despite the Fed's rate hikes. A yield at 4% or below is supportive of higher equity prices.
- With modest 2023 earnings cuts from here, the market will shift its focus to 2024 and the prospect of the S&P 500 generating in the neighborhood of $250 per share, which should drive the index back toward 5,000.
Some important earnings headwinds have now turned into tailwinds.
Exciting mega trends abound
Regardless of short-term gyrations in the economy and markets, several major long-term trends continue to gain momentum and will require multi-trillion-dollar investments over the coming decade. These include:
- The energy transition and decarbonization
- Digital transformation and automation, e.g., cloud services, metaverse, artificial intelligence, autonomous driving
- Military defense and cyber security fortification
- Gene editing and the biology revolution
- De-globalization and re- and near-shoring of manufacturing
Recession or not, the massive investment behind these trends will provide a healthy dose of potential new equity market winners.
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