A Delayed Reckoning

by Joseph V. Amato, President and Chief Investment Officer—Equities, Neuberger Berman

Equity markets had momentum coming into 2023, but has the economic data now become too bad for investors to ignore?

For several months, we have said that a slowing of inflation could provide a temporary tailwind to equity markets, but that weakening growth will eventually hit them with a stronger headwind.

Until last week, the rally that ended 2022 appeared to be gathering momentum into 2023. Did the economic data just become too bad for investors to ignore?

Disinflation Is Here

When to expect the turnaround in fortunes was one of the debates at the recent quarterly meeting of our Asset Allocation Committee (AAC). As some AAC members observed, while growth and earnings are likely to slow early in 2023, there are, in fact, bullish things for investors to focus on: Inflation is easing, central banks look set to taper rate hikes, and the dollar has been weakening.

December’s U.S. inflation data indicated cooling prices, especially in goods. Last week, U.S. Producer Price Inflation (PPI) showed factory gate prices falling faster than at any time since the height of the pandemic. And in Europe, thanks to energy-saving efforts, alternative fuels and mild weather, natural gas prices fell by half in December alone.

The most recent U.S. payrolls report triggered talk of soft landings, Goldilocks and an “immaculate disinflation.” It appeared to show that the economy could create 200,000 jobs a month, pushing unemployment to multidecade lows, without triggering an upward spiral in wages.

With officials at both the U.S. Federal Reserve and the European Central Bank speaking about a return to 25-basis-point rate increases, investors generally added risk in the new year—especially in Europe, where the Stoxx 600 Index, up 6.4% so far in 2023, is among the world’s best-performing markets.

The Economy Is Slowing

But the reason policymakers are thinking about tapering rate hikes is that they can see the economy slowing down. And the reason they are thinking about tapering, and not stopping, even at the risk of exacerbating the slowdown, is that they can see how sticky inflation might be.

Tumbling PPI suggests that companies are starting to struggle to pass on rising costs. Sure enough, weak U.S. retail sales for December, released at the same time last Wednesday, revealed an increasingly weary and wary consumer. U.S. industrial production data was also softer than expected.

Moreover, like the employment and inflation data, these are lagging economic indicators. Leading indicators present an even starker warning about the slowdown.

Purchasing Managers’ Indices (PMIs) have slumped over recent months. The S&P Global U.S. Manufacturing PMI is now at 46.2, recording its fastest decline since the pandemic. At the end of last year, we noted the resilience in services PMIs and warned it might not last; then, the Institute for Supply Management Non-Manufacturing PMI plummeted into contraction for the first time since May 2020. The S&P Global Eurozone Composite PMI has been in contraction since July last year.

Earnings Starting to Crack

Things are also beginning to look shakier from a company “bottom-up” perspective.

For the fourth-quarter earnings season, just under way, analysts anticipate year-over-year earnings growth for the S&P 500 Index to be down 3.9%, according to FactSet. Moreover, extreme sector dispersion—energy earnings are expected to be up more than 60%—could be making that look better than it is. Financials, especially capital markets players, are already reporting substantial earnings declines, pointing to a difficult growth environment ahead.

In Europe, analysts expect fourth-quarter earnings for the Stoxx 600 Index to be up 4.2%, year-over-year. But Europe’s smaller and less internet-oriented technology sector might be painting a flattering picture, relative to the U.S. index. Growth expectations for other sectors are similar to those for the S&P 500 Index.

The consensus forecast for 2023 S&P 500 earnings remains above $225 per share. We think this is optimistic and will likely come down.

Ultimate Reckoning

There is a significant wild card in play.

China’s officials are relaxing their “zero-COVID” policy, reopening the country and focusing on restoring growth. Last year, China’s economy grew just 3%—but its fourth-quarter data already indicates a pickup in momentum coming into 2023.

That could introduce meaningful demand back into the global economy. Indeed, that has likely been one reason for the positive sentiment toward European risk assets, which are particularly exposed to these dynamics. While this is good news for growth, it could be bad news for inflation. A stronger China will likely make central bankers’ jobs that much harder.

What would increase the chances of a soft landing in 2023? Certainly, a faster and more significant-than-expected decline in inflation. As of now, however, we think a soft landing is an increasingly narrow path.

There may be enough wiggle room in the economic data to sustain near-term investor sentiment, even after last week’s releases. In our view, however, the equity market faces very challenging growth and inflation dynamics. If this earnings reckoning doesn’t start to materialize in the first quarter of 2023, we believe it can only be delayed until later in the year.

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