Narratives have shifted away from the slower growth Fed pivot hopes that helped drive stocks higher in October and November. Risk-off factors are leading internals, tracing the weakening of economic growth and discounting uncertainty about upcoming earnings. Slower growth rather than changes in financial conditions is likely to be the more important driver of stocks in 2023.
Economic indicators such as US PMI and NY Fed Weekly Economic Index both are trending lower, and the service indicator retail sales reading also missed expectations last week. As we discussed in a report last week (HERE), NTM EPS earnings revision have fallen -3.7% from their peak. Even if a deep recession can be avoided next year, a sharp slowdown/mild recession (our base case) means revisions will continue to fall from here. The slowdown is here, and central banks are still erring on the side of crushing inflation.
We ran factor return correlations with the NY Fed Weekly Economic Index, a high-frequency coincident indicator of demand. We also looked at correlations with the US Manufacturing PMI, a lower frequency leading indicator. Both sets of correlations show similar trends and favor Low Volatility, Realized Growth, and Quality of Earnings during periods of slowing economic activity.
Sector return correlations support a Defensives position with Staples, Health Care, and Utilities performing best as growth indicators decline. Deep Cyclicals and the rate-sensitive Financials sectors struggle the most. Early Cyclicals correlations are mixed. Further slowing of the WEI is a mild positive for Early Cyclicals, while declining PMIs are a mild negative. At the edges, sector performance relationships with growth a strong and consistent, but for Early Cyclical groups, sector trends are weak and OTHER factors (fundamental and macro) are important.
At the end of this report we list the stocks with the more negative correlations with changes in NY Fed WEI and the US Manufacturing PMI. The basket is more Defensive, consistent with the highly negative correlations of Defensives to slowing growth.
Slower Growth Favors Quality Growth: Narratives have shifted away from the slower growth, Fed pivot hopes that helped drive stocks higher in October and November. December’s focal points have been the rapid deterioration of growth indicators and more hawkish than expected commentary from the Fed and ECB. Financial conditions have tightened modestly but are and will likely remain range bound. Risk-off factors are leading internals though, tracing the weakening of economic growth and discounting uncertainty about upcoming earnings. Slower growth rather than changes in financial conditions is likely to be the more important driver of stocks in 2023. Economic indicators such as US PMI and NY Fed Weekly Economic Index both are trending lower, and the service indicator retail sales reading also missed expectations last week. The slowdown is here, and central banks are still erring on the side of crushing inflation.
Historically, the S&P earnings trends are positively correlated with economic indicators. Slower growth begets declining S&P earnings growth expectations. 4Q estimates have remained firm but expect to see the typical pattern of negative revisions over the weeks heading into the start of reporting.
Forward earnings estimates for 2023 and 2024 continue to suggest positive growth at roughly the post-GFC and pre-COVID trend. Hopes of recouping the pre-GFC trend anytime soon are gone, but trend earnings are off their post-GFC, trend. As we discussed in a report last week (HERE), NTM EPS earnings revision have fallen -3.7% from their peak. Even if a deep recession can be avoided next year, a sharp slowdown/mild recession (our base case) means revisions will continue to fall from here.
We ran factor return correlations with the NY Fed Weekly Economic Index, a high-frequency coincident indicator of demand. We also looked at correlations with the US Manufacturing PMI, a lower-frequency leading indicator. Both sets of correlations show similar trends and favor Low Volatility, Realized Growth, and Quality of Earnings during periods of slowing economic activity.
Sector return correlations support a Defensives stance with Staples, Health Care, and Utilities performing best as growth indicators decline. Deep Cyclicals and the rate-sensitive Financials sectors struggle most. Early Cyclicals correlations are mixed. Further slowing of the WEI is a mild positive for Early Cyclicals, while declining PMIs are a mild negative. At the edges, sector performance relationships with growth a strong and consistent, but for Early Cyclical groups, sector trends are weak and OTHER factors (fundamental and macro) are important.
Looking at the current factor exposure of sectors shows Energy, Technology, and Industrials are all positively exposed to Realized Growth and Quality of Earnings. Staples and REITs also have high exposure to either Quality or Realized Growth, which is roughly in line with favored factor and sectors during periods of slowing of growth indicators. Energy, has the greatest exposure to Growth, but that exposure I less important as Energy returns remain highly macro (oil) driven.
At the stock level, we ran return correlations with both the NY Fed Economic Index and US Manufacturing PMI Index. The names with the most negative correlations to both indicators are listed below. The basket is more Defensive, consistent with the highly negative correlations of Defensives to slowing growth.
