By
Ankit Agrawal
July 18, 2022
We are witnessing one of the most difficult macro environments in many of our lifetimes and yet it is an exciting time for macro investors and asset allocators. Almost everyone expects equities to suffer more pain given slowing PMI momentum across regions, negative consumer and business sentiment and yet central banks tightening ever more aggressively in the face of stubbornly high inflation. If we consider the average maximum decline in S&P 500 over the past 4-5 major recessions to be around 40-50%, the 25% drawdown this year seems to indicate only a 50-60% pricing of such a scenario.
As we enter the 2Q earnings season in the US, we believe it is now the turn of earnings to start feeling the pain.To put this in context, since the start of the year, S&P 500’s earnings estimates for 2022 have actually been revised up approx. 4% which means valuations have been the driver of the move lower in equity prices. Even today, when we look at the last 1m change in these estimates, it is +0.3%. However, we are seeing wide dispersion across sectors with energy and tech holding up quite well while the other cyclical sectors taking the brunt (chart 1).
Given we are in July, it would only be prudent to start looking at 2023 estimates as markets discount forward earnings. If we look at the same 1m change in 2023 estimates (chart 2), we still see S&P 500 estimates hold up quite well. However, a closer look tells us that it is energy and tech that have kept the index afloat. Barring these 2 sectors, there is considerable weakness in earnings estimates for next year. More importantly, we would point to a) materials sector estimates that have started to roll over (chart 3), and b) semiconductors where estimates have been slashed massively. If we look at other growth sectors outside tech, e.g. consumer discretionary and communication services, we see a consistent downward revision trend there as well (chart 4).
Now, in this set up one would normally be inclined to rotate into defensive sectors like Utilities and Staples. However, when we look at valuations of these sectors relative to the S&P 500 on a 12m forward basis, they seem quite expensive (charts 5 & 6). Hence, we believe rotating into these sectors today doesn’t present an attractive risk-reward.
Traditionally, earnings estimates coming down have been a lagging indicator and S&P 500 price has consistently bottomed 6-12m ahead of a bottom in earnings. While this is not a call on market bottom, we believe we are heading into the second stage of the sell-off, where it is the turn of earnings to take the hit and more investor pessimism leading to peak panic before the bottom sets in. Well, at least that’s been the playbook.
Source: Bloomberg, Kristal Investment Advisory. Alldata as of 12July, 2022
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