Maintain 2.5 Stars on US equities: Aggressive rate hikes might put the US on a recessionary path

• US equities have gotten off to a rocky start in 2022. At the midway point of the year, the S&P 500 index is already in bear market territory, while inflation continues to be red hot. 

• We fear that the Fed’s aggressive response to tackle inflation might lead to a sudden tightening of financial conditions, which could put the US on a recessionary path.

• Higher prices, negative real wages, and lower savings all point to waning consumer spending, which should negatively affect economic growth. 

• Even though GDP estimates for 2022 have been revised down significantly, earnings are still expected to grow 15% year-over-year. Earnings estimates are likely to be overly optimistic and thus we expect more downward revisions to come. 

• We maintain a 2.5 Stars “Neutral” rating for US equities. Investors who are still keen to remain in the US equity space may want to consider adopting a value tilt. 

US equities have gotten off to a rocky start in 2022 

US equities did not get off to a good start in 2022. As of 30 June 2022, the S&P 500 Index, which ended the previous year near an all-time high of 4,818, is already down by more than -21%, putting it in bear market territory (Figure 1). 

Figure 1: At the midway point of the year, the S&P 500 is already in bear market territory

The lackluster performance comes as the world’s largest economy faces a number headwinds since the beginning of the year, such as a sudden surge in COVID-19 cases and the Russia-Ukraine crisis. To make matters worse, inflation in the US continues to run red hot. 

After an unexpected gain in May, inflation rose again in June, this time by 9.1% year-over-year - the highest in over 40 years (Figure 2). While the increase was broad-based, components such as food (+10.4%), energy (+41.6%), and shelter (+5.6%) were the largest contributors to June’s inflation numbers.

Figure 2: US consumer prices rose by 9.1% year-over-year in June 2022

However, given that inflation today is driven more by supply side issues (e.g. rising food protectionism, underinvestment in the oil and gas industry) rather than demand, we expect inflation to stay higher for longer, at least until the various supply side issues are resolved. 

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Fed’s aggressive response raises the likelihood of a recession 

With consumer prices showing little signs of cooling, the Fed has been forced to take some of the most drastic measures in recent history – raising rates by 75 bps. More importantly, minutes from the latest Fed meeting warned that “more restrictive policy” may be implemented if inflation fails to come down. We fear that the sudden tightening of financial conditions may be too much for the economy to handle, and it could put the US on a recessionary path. 

As a matter of fact, the Conference Board Leading Economic Index – a composite index that tracks 10 leading economic indicators in the US – has been on a downtrend since it peaked earlier in April, suggesting that the US economy is likely to slow even further in the months ahead (Figure 3).

Figure 3: Leading indicators are already pointing towards a slowdown in the economy 

As inflation remains elevated and financial conditions tighten, businesses are likely to be faced with tougher operating conditions (e.g. higher input, borrowing costs and deteriorating margins) which will likely result in lower earnings growth and hence lower equity prices. 

In response to rising wages and input costs, companies might opt to exercise their pricing power more aggressively, passing on these costs to consumers by raising the prices of their goods and services. In the recent CEO confidence survey conducted by The Conference Board, 54% of CEOs said that they intend to manage rising input costs by passing them on to consumers (Figure 4). This in turn adds to inflationary pressures which can strain consumer finances even further.

Figure 4: The majority of all CEOs surveyed said that they will be passing on higher costs to consumers. 

If financial conditions continue to tighten, businesses may be forced to dial back on expansion plans, which can produce a negative impact on the labour market. Although the labour market is still relatively tight at the moment, cracks are starting to emerge. For one, the number of initial jobless claims has been on an uptrend in the recent months and is currently above its pre-pandemic level.

Lately, several companies have also announced hiring freezes and even layoffs, another sign that the labour market is starting to loosen up (Figure 5). The majority of the layoffs came from sectors of the economy that have done well during the pandemic, such as tech, as well as interest rate sensitive sectors like housing. Overall, we expect the number of layoffs to increase gradually as the effects of tighter monetary policy kicks in, fanning the flames of a recession. 

Figure 5: US job cuts inch up as the economy slows 

Weakness in consumer spending points to further economic slowdown

The US economy is driven mainly by consumer spending, which accounts for approximately two thirds of total GDP. As such, the health of consumers and also their attitudes about the current and more importantly future strength of the economy are key factors that can give us clues as to whether or not consumption will continue to grow or falter in the future. 

At this juncture, things are not looking good, with most signs pointing towards an impending slowdown. For one, the consumer confidence index has tumbled to a record low of 50.0 in June from 58.4 in May. What is more worrying is the sharp decline in the expectations index, which fell to 47.5 in June versus 55.2 the month before (Figure 6). 

Consumers cited strong concerns about how the deteriorating labour market outlook and persistently high inflation – especially for food and gas prices – will continue to erode their incomes. Roughly 79% of consumers expect business conditions to worsen in the year ahead, the highest since 2009. Adding to the woes of consumers is the fact that wages are struggling to keep up with inflation. In the month of May, inflation adjusted incomes fell by -0.1%. 

Figure 6: Consumer confidence continues to tumble in June

While consumption has remained relatively robust thus far, the rate of growth has slowed substantially. On a nominal basis, consumer spending rose by 0.2% in May, the smallest monthly gain this year. After adjusting for inflation, consumer spending actually contracted by -0.4%. This means that consumers are actually buying less goods, but are paying higher prices. 

Meanwhile, the savings rate, which peaked during the pandemic, has fallen at an alarming pace. Not only is the savings rate currently below pre-pandemic levels, it is also sitting near the lowest level over the past decade. Meanwhile, credit card debt has risen. In the first quarter of 2022, credit card balances reached a total of USD 841 billion, a 9.2% increase compared to the same period a year ago (Figure 7). 

Figure 7: Savings rate down, but credit card debt up 

Both these trends suggests that consumers have been dipping into their savings and taking on more debt in order to keep spending – a move that is probably going to be unsustainable especially if inflation stays elevated and the Fed continues to hike rates aggressively. 

Similar to other types of credit, credit card rates tend to mirror the movements in the Fed Funds Rate (FFR). In line with the sharp increase in the FFR, the average annual credit card interest rate in the US also saw a sharp increase, from 14.5% in February to 15.1% in May. This is without a doubt bad news for the 53% of American credit card holders that carry a balance on their cards. 

With consumers already feeling the heat from rising prices and negative real wages, higher borrowing costs will only add to the pain. Looking ahead, consumer spending is likely to decline, resulting in slowing economic growth and increasing the risk of a recession. 

Consensus earnings estimates likely to be overly optimistic 

With the US economy on a much weaker footing that before, GDP growth estimates have been revised down significantly. As of 18 July 2022, GDP growth for 2022 is expected to be 2.1%, compared to 3.9% at the beginning of the year. Earnings for the S&P 500 Index, however, paint an entirely different picture, with an upward revision of close to 5% (Figure 8). On a year-over-year basis, earnings growth is expected to be 15%. 

We feel that the consensus is overly optimistic, and the weaker economic outlook has not been fully priced into earnings estimates. That said, there is a high probability that earnings could see negative revisions in the months ahead. 

Figure 8: Consensus earnings growth likely to be overstated, downward revisions are likely to follow

The second quarter earnings season has gotten off to a slow start, with both the number and magnitude of earnings surprises falling behind the average over the past few years – a sign that earnings are starting to look shaky. Among those that have already reported, the aggregate earnings surprise is only 2.7%, way below the five year average of 8.8%. 

On top of that, sales grew by 5.5% but earnings, on the other hand, contracted by -14.5%. The disparity between sales and earnings shows that companies are starting to struggle with cost pressures coming from higher input costs (e.g. raw materials & wages). Going forward, as the narrative of higher input costs and tighter financial conditions continues to play out, we expect margins to deteriorate, ultimately affecting earnings.

Maintain 2.5 Stars “Neutral” rating on weaker earnings and valuation compression

Although US equities have experienced a correction since the start of the year, valuations are still far from being incredibly cheap. Aside from the potential negative earnings revisions, valuation multiples are also likely to compress as financial conditions tighten, leaving limited room for US equities to appreciate. 

Tighter financial conditions tend to drive a compression in equity valuations, by discouraging risk taking behavior, while at the same time increasing the incentive to invest in safer assets such as US treasury bonds. With less money chasing a limited pool of assets, equity valuations should naturally contract (essentially the opposite from what has happened since the 2008 global financial crisis).

We expect rising rates to pose a key challenge for equity valuations, especially for the more richly valued areas of the market such as tech (future cash flows are worth less). History has shown that whenever the Fed raises rates, valuations have either fallen or at best levelled. In addition, we observed that the more aggressive the pace of rate hikes (i.e. higher rates in a shorter time), or the expectation of it tends to result in a larger valuation compression.

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Last but not least, higher rates also tend to make equities less attractive compared to fixed income on a relative basis as the spread between earnings and bond yields tightens. With all this in mind, we have decided to lower our fair PE multiple for the US market from 20X to 18X to better reflect expected economic conditions. Based on this, our estimated upside potential for the US market is approximately 12%. 

Table 1: Earnings growth likely to revised down as the economy slows

Figure 9:  In the long run, share prices are driven by earnings 

To sum things up, based on current valuations, US equities are still not as attractive as other markets under our coverage, hence we have decided to maintain a rating of 2.5 Stars “Neutral” for the region. As we head further into 2022 with inflation running red hot and the Fed not looking to take its foot off the tightening pedal, the chances of a soft landing are getting slimmer. 

We recommend investors to underweight US equities and remain cautious when it comes to sector and stock selection. Looking beyond US equities, investors can also consider markets with relatively cheaper valuations such as China, Asia ex Japan and ASEAN. That said, investors who are still keen to remain within the US equity space may want to consider adopting a value tilt, which can be implemented easily using value-oriented funds such as the JPMorgan Funds - US Value A (acc) USD. 

Table 2: Recommended products for US equities 

Declaration:

For specific disclosure, at the time of publication of this report, IFPL (via its connected and associated entities) and the analyst who produced this report hold a NIL position in the abovementioned securities.