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Outlook: Earnings Recession, QT And Volatility

International | Sep 07 2022

Equity markets are moving into Phase 2 of the 2022 general re-adjustment, experts say.

-Moving from peak earnings and record operating margins to an earnings recession
-The impact of Quantitative Tightening (QT) on equites and financial assets
-Further downside risks to shares in 2022
-This is not a secular bear market, volatility will offer great opportunities

By Danielle Ecuyer

June represented a short-term oversold bottom in equity markets, and a perception by some the Federal Reserve would revert to a pivot, offering markets a false narrative that the “Fed put” was in the offing.

Equities rallied off the lows.

Alas, according to many experts, we are still only in the second or maybe third inning of the re-adjustment to higher interest rates and inflation.

Jerome Powell confirmed at the Jackson Hole symposium the Fed is in for the long haul, to bring inflation back under control. Changes in the Fed funds rate will be dependent on future economic data points.

For now, you’d be wise to assume interest rates are still rising and while the inflation trajectory may move down, there is a groundswell of opinion that this Fed is not going to repeat the mistakes of Arthur Burns in the 1970s who eased too quickly, serving to embed inflationary pressures and expectations for the following decade.

The next innings – earnings recession

If we zoom out to what transpired in equity markets over 2022, we have a tale of two stories, explains Morgan Stanley’s Chief US Equities Strategist, Mike Wilson, “Fire and Ice”.

The first six months of 2022 were the ‘fire’ phase, the analogy alluding to the valuation compression (lower multiples).

The 12-month forward PE ratio for the S&P500 fell almost -30% to 15.5x from 21.5x as markets recalibrated for the impact of higher interest rates.

In a recent interview with David Rosenberg, Wilson describes the reversal in the operating leverage (margin compression) for companies as one of the significant risks to future earnings, the ‘ice’ phase.

US second quarter earnings results ex-energy came in -10% below where expectations had commenced in early 2022.

Hardly a shoot the lights out result, but US companies managed expectations over May and early June in pre-empting the ‘less bad than feared’ outcome.

S&P 12-month earnings forecasts currently stand at US$236, notes Wilson, down -US$4 from the recent high and some US$60-US$70 above the previous cyclical highs.

According to Morgan Stanley’s modeling, 12-month forward earnings can fall by -5% to -15% from the current US$236, to between US$186 and US$207.

A soft case landing, although not anticipated by Wilson, equals S&P earnings of US$210-US$215.

Valuing these prospective earnings at 15.5-16.0x equates to an S&P500 index level of circa 3200 for earnings of US$210, with further downside risk if the earnings recession is more severe.

The S&P500 closed at 3908 overnight.

The pressure on operating margins as evidenced in the US June quarter results has room to increase as inflationary pressures bite and earnings struggle when compared to the higher base following the pull forward of demand during the pandemic.

Quantitative Tightening (QT) the unknown quantity

QT will ramp up during September with the Federal Reserve reducing its balance sheet by -US$90bn per month, up from -US$17bn in the prior three months.

According to the WSJ, “the Bank of America equity strategist Savita Subramanian says QT alone could lead to a 7% stock price drop as the boost from QE is reversed.”

The combination of higher rates, earnings revisions and QT are an adverse cocktail for financial asset prices. The opposite of what most investors had become accustomed to, notably QE and lower-for-longer interest rates.

The key question is how long can the Fed persist with QT and whether the tightening will create a forced liquidation event when asset managers are left with no option to sell?

Wilson views the time frame from mid-September around the next FOMC meeting until the US mid-term elections as a period of angst and uncertainty for investors.

On balance though, he doesn’t think the Fed will be able to shrink the balance sheet in a meaningful fashion with so many headwinds.

Viktor Shvets, writing in his own personal capacity on LinkedIn and not as Managing Director of Macquarie Securities, makes the point that the world has moved on from the late 1970s and early 80s.

Shvets refers to the ‘financialisation’ of the world, with 3-4x more leverage (indebtedness), while corporate and household balance sheets are tied to asset prices.

His scenario is for more compressed cycles from recession to recovery occurring over shorter periods, on the assumption that inflation is not as embedded as during the lost decade of the 70s and the disinflationary influence of digitalisation provides more flexibility.

Wilson considers the current events as more of a ‘boom-bust’ cycle, akin to what transpired in the late 1940s and early 1950s and does not view the current bear market as a secular one.

When will the Federal Reserve pivot

The FT reports Greg Fleming of Rockefeller Capital Management has looked at 50 years of historical data showing the Fed always waits for inflation to fall below the Fed Funds rate.

This implies there is scope for rates to remain at 3.5% to 4% in the US over the next 6 to 12 months.

London based Capital Economics reportedly does not see US interest rates fall until 2024, although the RBA is seen cutting rates in 2023.

Capital Economics’ year-end 2022 S&P500 target stands at 3600. Morgan Stanley’s target is 3900.

Investors should expect more volatility in financial asset prices as economic data points come through, earnings forecasts come under pressure and the ever-expectant bond and equity markets try to forecast the trajectory of the Fed fund rate.

For some experienced market experts, like Will Hamilton of Hamilton Wealth Partners who has lived through every bust since 1987, the coming period translates into a great buying opportunity with a long-term focus.

And while ideal entry levels might well be 6-9 months out into the future, Hamilton predicts equity market lows will be reached before the trough in the economic cycle.


Danielle Ecuyer has been involved in share investing in Australia and Internationally for over three decades, both professionally and personally and is the author of ‘Shareplicity. A simple approach to investing’ and ‘Shareplicity 2. A guide to investing in US stock markets’.

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