Investors have been puzzled this year as an inverted US yield curve, alongside economist forecasts and CEO surveys, signalled an impending recession, while the outperformance of risk assets such as equities and high yield debt, reflected a much brighter outlook. Consensus earnings forecasts project rising profits instead of the declines one typically sees in a recession.
One possible explanation for the apparent divergence in views between the markets could be simply that one market is right and the other wrong and that eventually they will converge – assumedly equities fall once the market realises a recession is actually in store. While this is possible, it seems unlikely that markets could sustain such a schizophrenic view for so long.
Assuming the current yield curve inversion implies a recession as it has done in the past could also be mistaken due to quantitative easing. That is, perhaps the yield curve would not be as inverted, or inverted for as long a time, if the Federal Reserve had not accumulated USD 7.5 trillion in Treasuries and mortgage-backed securities?
There is another explanation which reconciles the apparent contradiction in the markets: that the interpretation of the inverted yield curve as a recession signal is mistaken. While it is true that historically an inverted curve has very often been followed by a recession, it is not inevitable that it does. The inverted yield curve simply reflects high interest rates today as central banks aim to slow economic growth and hence inflation, and lower interest rates in the future once growth and inflation decline. That is, the inverted yield curve – accurately – forecasts a slowdown in growth, but that slowdown does not have to end in recession. This is not to say current market pricing excludes the chance of a recession, just that it reflects a scenario where the probability of a slowdown is greater than the probability of a recession.
There are two reasons why things may be ‘different this time’, with the inverted yield curve not being followed by a recession. Previous recessions have arguably been caused by central bank policy mistakes, that is, raising rates too high or for too long. The US Federal Reserve (Fed) is clearly aiming today for a soft landing, however, and may err on the side of letting inflation stay higher for longer, as long as it is declining, rather than raising rates more aggressively in order to get inflation back to target quickly. It is worth noting that at the June FOMC meeting, not only did the Fed pause its rate hikes, it also raised its inflation projection for 2023.
The other key difference is that the US economy is in a different state than during previous slowdowns. Thanks to fiscal stimulus, consumer demand remains very strong. Personal consumption expenditures rose by 4.2 per cent(SAAR) in the first quarter. The headline 2 per cent GDP growth rate was reduced due to the drawdown in inventories, but the drawdown was itself a reflection of the very strong consumption. Retail sales over the last few months show US consumers still motoring along.
If GDP growth is merely expected to slow to a below-trend rate, say, 1.75 per cent in real terms for the US, it is perfectly reasonable that equities would rise. Following the very negative market returns last year, a recovery in equity indices in 2023 was anyway to be expected. Analyst forecasts for positive earnings growth in the quarters ahead should also not be surprising. Remember that as inflation is falling only slowly, even factoring in consensus economic forecasts of a recession this year, the US economy is still expected to grow by 3 per cent in nominal terms over the next year.
As we enter the second quarter earnings season, US consensus earnings estimates have already been revised down and earnings growth (ex-energy) is expected to be around zero this quarter. For the rest of the year and into 2024, however, expectations are much higher: 6 per cent for the third quarter, 14 per cent for the fourth, and a similar rate in 2024. These forecasts are likely too optimistic, as year-ahead forecasts almost always are.
The 2024 US forecast of 14 per cent EPS growth seems particularly high given that historically realised earnings growth has been closer to 9 per cent. Underneath the headline estimate, though, there is an important divergence between the expectations for non-tech stocks, whose earnings are expected to rise by 10 per cent in 2024 (average), versus 19 per cent for the technology sector (above average). While the growth rate for tech stocks is elevated, it results in a level of EPS in 2025 that is not far off what one would anticipate given previous rates of growth since the global financial crisis.
Optimistic projections mean that earnings revisions are likely to be negative, but still-positive earnings growth should support prices over the medium term. The market vulnerability lies more in valuations for tech stocks than in earnings. The current forward multiple on the NASDAQ 100 is 27x earnings, well above the average of 19x, while for the ‘non-NASDAQ’ parts of the S&P 500, the multiple is 15.7x, only slightly above the long-run average of 14.5. The NASDAQ price-earnings ratio has notably increased since the banking sector turmoil in March, even as real yields have risen by 50bp. Normally the correlation between growth stock valuations and real yields is negative, but because of enthusiasm around artificial intelligence (AI), valuations have continued to rise. To normalise the multiple, equity prices will either have to appreciate at a lower rate than earnings, or prices will need to fall.
