I have mixed memories of my first Thanksgiving, soon after I went to study in Massachusetts in 1985. Kindly invited to a friend’s family celebration, I was driving my clapped-out Chevy station wagon (1971, beige, $200) through a snowstorm when one of the back wheels quite literally fell off. I was grateful, I suppose, that the conditions were so awful that I was travelling very slowly and was able to retrieve the bolts from the roadside and get on my way.
As Americans settle down to eat their turkey, they are likely to feel equally ambivalent about the blessings of 2022. It’s been a forgettable year, not least for investors who can be forgiven for not being particularly grateful. Inflation, a determined US Federal Reserve (Fed) and growing recession fears have combined to deliver the worst year for Wall Street since the financial crisis.
Peak to trough, the S&P 500 lost 25pc from its January high point and while there have been two meaningful rallies since the US summer, they both ran out of steam. The most recent recovery feels like it is heading the same way after last week’s hawkish comments from St Louis Fed chair, James Bullard.
The drop in 2022 was all about lower valuations. The market did its job to perfection, anticipating the impact of higher interest rates on the economy and pre-empting the economic slowdown that looks likely to characterise 2023. Having started the year priced at around 24 times expected earnings, the S&P index has been as low as 15 and stands today at about 17. The valuation reset is largely in place. But next year the market will turn its attention to earnings.
Three outcomes seem plausible for the US market in 2023. The first, muddle-through scenario is nicely categorised by Goldman Sachs in its year-end Outlook as ‘less pain but no gain’. It assumes a soft landing for the US economy, leading to a high but flat cost of capital for American businesses, broadly unchanged earnings next year compared to this, a stabilised valuation multiple and, consequently, a stock market that ends the year essentially where it is now.
In the early months of next year, according to this scenario, it will become clear that the Fed has got on top of inflation. Increasingly small hikes will finally stop in May, but interest rates will remain not far off their 5pc or so peak as the central bank strives to keep growth below trend. Unemployment will rise, but not by much, and the US economy will avoid recession.
The second, much gloomier scenario sees the delayed impact of all those jumbo rate hikes kick in. That, or another external shock, will tip the US economy into recession, leading to a double digit fall in corporate earnings. Historically when there is a recession, profits fall by around 13pc and there’s no reason to think that this downturn would be much different. Were that to look likely, it is probable that the valuation multiple would fall too, perhaps to 14.
Put the two together and the likely year end value of the S&P 500 would be closer to 3,000 than 4,000. At that level, incidentally, the US market would have fallen by just over a third from its peak at the beginning of this year. If that sounds a lot, it is actually pretty normal. In 12 post-war recessions, the average market fall has been 30pc.
The third possible scenario is one to which I assign a non-trivial probability. It is that investors see the way the wind is blowing quite early in 2023 and start to price in recovery well ahead of its emergence in the backward-looking economic data. Whether we get this benign outcome or not depends to a large extent on the economic landing. Soft or hard will be key.
This is because, while the market response to a perceived peaking in bond yields is predictable in the short run (shares have risen 7pc in the first three months on average since 1980), in the year after peak tightening the outcome depends on whether the policy squeeze creates a recession or not. When there’s a recession, the early market gains evaporate. When there’s a soft landing, returns of 20pc or more are possible.
The lag between the turn in the market and the low point for the economy is also extremely variable. On average since the second world war, markets have tended to bottom out 6 weeks or so ahead of the turn in the economy. But this average is skewed significantly by the unusual situation after the bursting of the dot.com bubble. That valuation-driven bear market lingered for a year after the end of what was a very short recession (caused more by 9/11 than the technology bust). Strip this out and a more realistic expectation is that markets turn several months before the economy.
If you think the actual outcome lies somewhere between Goldman’s neutral and pessimistic scenarios, you will rightly be pretty cautious about increasing your exposure to the US next year. What’s the hurry you might think if the best case is no change and the worst another 20pc drop?
In my experience, however, markets don’t tend to go sideways for long. They fall and then, without anyone ringing a bell, they decide it’s time to go the other way again. And that is what I expect to happen in the first half of next year. Once investors decide that the Fed has done its job, beaten inflation without tipping the economy into recession, the market will head higher again. By next Thanksgiving, I think we’ll have something to be grateful for. Including, in my case, a better car.
