Uneven growth outlook favors selective approach

After a bleak 2022, the S&P 500 is on track for a strong January. The index rose 2.5% last week, and has gained 6% year-to-date. Falling inflation and relatively resilient economic data have boosted hopes of a “soft-ish” landing for the US economy. The Federal Reserve looks set to slow the pace of rate hikes further at its policy meeting this week, to 25 basis points (bps) from 50bps in December.

But despite the solid start to the year, uncertainty about the outlook for growth and inflation remains high:

The US economy is slowing, and we think a trough is still some way off

US GDP grew at a 2.9% annualized rate in the fourth quarter of 2022, slightly better than consensus forecasts but a deceleration from 3.2% growth in the third quarter. However, around half of overall GDP growth came from rising inventories, and declining imports of goods contributed another 0.7 percentage points. This suggests that the economy may not be as strong as the GDP growth rate would imply. Residential investment fell 26.7%, the seventh consecutive quarter of negative growth.

More recent data indicate that the US economy is cooling as the impact of 425bps of Fed rate hikes in 2022 feeds through, and growth is likely to slow further in the months ahead. The Conference Board’s index of leading economic indicators fell sharply in December. The S&P Global composite purchasing managers’ index (PMI) for the US remained in contraction territory in January, at 46.6—in contrast to the Eurozone PMI, which edged back above 50.

Corporate earnings remain lackluster

With fourth-quarter results in from 40% of the S&P 500 by market cap, beats continue to be lower than normal. Just 64% of companies are exceeding earnings estimates, compared with a historical average of 73%. Consumer spending has remained supported. But there are also areas of weakness—including in housing, goods, PCs, digital advertising, and cloud spending.

In aggregate, S&P 500 earnings are topping consensus forecasts by a little less than 1%, lower than the normal beat of about 4%. The median company has cut 1Q23 EPS guidance by 2.1%, and analysts are downgrading their estimates at a slightly faster pace than the historical average. We think corporate profits will remain under pressure in the coming quarters, and are looking for a 3-4% decline in S&P 500 EPS in 2023 to USD 215.

Inflation is moderating, but the US labor market is still tight

The core PCE price index rose 4.4% year-over-year in December, its smallest annual increase since October 2021. But while price pressures are easing—giving the Fed the leeway to slow rate hikes further to assess the impact on the economy —policymakers are likely to need more evidence of a cooling labor market to alleviate concerns about wage growth. Data released last week pointed to continued tightness: The four-week rolling average of weekly initial jobless claims fell below 200,000 for the first time since May.

So, for now, the backdrop remains one of slowing growth and earnings, above-target inflation, and tight monetary policy. Until a trough for the US economy and global corporate earnings is more clearly in sight, we expect equity markets to be volatile. With the S&P 500 forward price-to-earnings ratio approaching 18x, we think the risk-reward trade-off for the broad US market looks unfavorable in the near term.

As a result, we are selective in our positioning. Within equities, we prefer the consumer staples, energy, and healthcare sectors, quality-income stocks, and value over growth.

We also recognize that dispersion between geographical regions and sectors is likely to be elevated in the current environment. For example, we think China’s reopening and Europe’s warmer-than-expected winter create opportunities in areas of the market that are likely to anticipate inflection points sooner than others. These include emerging market and German equities, European consumer stocks, and select companies across regions that should benefit from China’s reopening. We also like broad commodities, emerging market bonds, and the Australian dollar.

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