Rates…Rats!
Rates…Rats
Summary
Recent market action has been unsettled, an environment requiring a steady hand and disciplined management. At Roanoke, we believe in the power of the American system to support innovation leading to improved efficiency, higher labor productivity and ultimately sustained economic growth in the long-run and get excited when we’re able to add long-term winners to your portfolio during times of heightened trepidation. While there exist sources of uncertainty and a number of unambiguous headwinds in the near-term outlook, we, paraphrasing the former Vice President, reject those nattering nabobs of negativity who suggest that the engine of economic innovation that is the American system is broken; Further, history reminds us that what is known is priced in, and while investors with short-term time horizons are sellers, they create unique opportunities for those of us seeking to grow wealth over the long-term.
Market and Economic Commentary
Extending their worst first half performance in over 50 years, equities fell further in the Q3, with the S&P 500 Index down 4% to close at $3571. Year-to-date, the market is down 23%, comfortably in bear market territory. Persistently high inflation, a drop in consumer and business confidence presaging shortfalls in corporate earnings, continued lockdowns in China and unprecedented dislocation in the currency markets rattled investors during the period.
Fixed income, generally seen as a haven for the risk averse, has been a disaster, dropping 15-20% year-to-date depending on duration. As of this writing, ten-year treasuries are yielding nearly 4%, up from 1.6% at the beginning of the year and 50 basis point higher for the quarter.
The doom and gloom in the market’s trajectory reflects a deteriorating earnings picture across many sectors of the U.S. economy. While overall 2Q earnings advanced smartly, up nearly 10% for the period, much of the gain was driven by a 250% increase in energy sector profits. Excluding energy, earnings declined year over year. Insofar as energy prices have dropped over 30% over the past 90 days, this earnings tailwind is likely to moderate in the 2H, suggesting negative headline earnings for the market as a whole through at least early to mid-2023.
Our point of view is that the macro picture is currently distorted by the reversal of historic fiscal and monetary policy accommodation exacerbated by supply chain disruptions rooted in pandemic-related demand shifts and lockdowns in China. While these factors may take several years to fully normalize, we are highly confident that, on a year-over-year basis, CPI and PPI growth will moderate as the large increases of the past 12 months are anniversaried.
Indeed, the Fed’s Survey of Consumer Expectations reported inflation expectations have declined over each of the following one- three- and five-year forecast periods, with the 5-year pegged at 2.0%. Sharp reductions in money supply growth - from double-digit levels observed throughout the pandemic to just 4% in August, 2022, as well as recent U.S. dollar strength and a collapse in key commodity pricing, also augur for moderating inflation. Fixed income markets signal likewise with the yield curve solidly inverted; the 2-10 spread is currently negative 46 basis points, a level not seen since 1982.
Each of the last four recessions has been preceded by an inverted yield curve, with peak inversion observed coincident with the beginning of recession in 1980 and 13-16 months prior to the start of recession in July 1990, March 2001 and December 2007.
We often remind ourselves of the old adage “they don’t ring a bell at the bottom.” Markets don’t turn when the light at the end of the proverbial tunnel is visible, they turn when prospects appear most bleak.
Current earnings estimates for the S&P 500 Index range from $205 to $215 for 2022 while profits are expected to rise 9% in 2023 to $235. As such, as of September 30th, the market is trading at 16.6 and 15.2 times CY 2022 and CY 2023 earnings respectively, sharply below the Index’s 5-year average and in line with the 25-year trendline. We expect estimates to continue trending lower through early to mid 2023 as macro weakness translates into reduced profitability. A 10% estimate shortfall for 2023 puts the earnings target for the period at $212. Given where risk-free rates are today and taking into account forward rate expectations, we see the market trading between 14 and 19 times earnings over the next 12-24 months, implying a price range of 2968 - 4028 over the next 6-9 months and 3250 - 4400 by the end of 2023. Accordingly, we find the risk/reward profile for equities to be favorable, especially for investors with a 12-18 month time horizon.