SUMMARY: With the small increase in “super core” inflation (core CPI ex auto and rents) it is increasingly clear the Fed will pause after raising 25 basis points this month. The sharp decline in 2yr yields and fed funds futures confirms that view. The “easy” part of disinflation has happened and now we are on to the second stage. The second stage might be much more difficult if wages stay elevated, but that is a worry for 4Q23, when inflation comps become more difficult. For now, the backdrop is one where inflation is declining from a very high level, but is less of an immediate concern for the Fed (financial conditions don’t tighten). At the same time, economic data is non-recessionary. That is supportive of risk-on internals (small caps, deep Cyclicals, retail, transports, and Earnings Turbulence names).
Earnings are the next swing factor. The absolute level of inflation remains high and implies less downside risk to revenue growth and margins this quarter. Recent gains in margins/earnings sentiment indicate another quarter of flat to modestly higher margins, likely keeping the risk-on trade intact short-term. However, profitability is expected to accelerate into the end of the year and improve significantly in 2024. Below trend GDP growth for longer, which is required to push core inflation lower, increases the risk of negative revisions to 2024 estimates.
FYI, Brian Herlihy, our head of Quant Research, is hosting his quarterly earnings preview today at 2 PM ET. It’ll be no more than 30mins. Registration link HERE.
SMALL CAP FAIR VALUE: As we mentioned yesterday (HERE), we like small caps relative to large caps. Small caps have a more risk-on factor profile and benefit from a more optimistic economic narrative. Small caps are somewhat attractive on an absolute basis under a no recession scenario. Applying the same fair value framework to the S&P 600 that we use on the 500, fair value, with no recession, is ~1,300, or about +7% from here.
We walk through the fair value calculation and assumptions we make in the full report below…
MARKET VIEWS: The CPI report was favorable for risk assets. Super core only rose +3bps m/m (consensus was +46bps). Gerard thinks “it is increasingly clear that the Fed will pause after raising 25 basis points this month” and that the rate reaction is justified (2yr -13bps, an 8th %tile move). We’d be careful extrapolating CPI in a volatile data backdrop. The second stage of disinflation will probably still be more difficult and will probably still require further loosening of the labor market. For now, though, the data is another support to the risk-on trend. It’s difficult to step in front of that trend for a disinflation problem that will play out later this year.
Earnings are the next swing factor. the absolute level of inflation remains much too high (core CPI 4.8% y/y), which has two implications related to earnings. 1) There is less downside risk to revenue growth and margins this quarter, and 2) because the Fed cannot allow growth to accelerate meaningfully, medium-term EPS growth trend will remain under pressure. Recent gains in margins/earnings sentiment indicate another quarter of flat to modestly higher margins, likely keeping the risk-on trade intact short-term. However, profitability is expected to accelerate into the end of the year and take off in 2024. With rates higher for longer, growth slower for longer, and core services inflation biased lower, there is a growing risk of negative revisions to 2024 estimates.
SMALL CAP FAIR VALUE: As we mentioned yesterday (HERE), we like small caps relative to large caps. Small caps have a more risk-on factor profile and benefit from a more optimistic economic narrative. The Russell has outperformed the S&P by +3.5pp while the yield curve has steepened +19bps over the past week.
The performance and valuation gap between small and large caps after mega caps outperformed to start 2023 has gotten extreme, something we are wary of in a mean-reverting market. Small caps PEs have recovered some but are still below their medians relative to SPX and NDX. And performance spreads after the beginning of 2023 had only been outdone in the tech bubble and COVID.
Small caps are somewhat attractive on an absolute basis under a no recession scenario. Applying the same fair value framework to the S&P 600 that we use on the 500, fair value, with no recession, is ~1,300, or about +7% from here. FYI the fair value calculation we use is based on valuation guru Aswath Damodaran’s work (HERE). It’s a cash return model, akin to valuing a single stock with a DCF model. The calc is based on an expected earnings path, risk free rate (10yr), cash return (historical comp), and equity risk premium (excess return investors are demanding for taking risk). We walk through the assumptions below…
Assumptions:
ERP is the non-recession median.
EPS growth trend is the long-term median.
EPS estimates are consensus this year, trend growth rest of the way.
LT EPS growth falls towards the long-term risk-free rate. Since small cap earnings growth is usually better, we bump long-term eps to 5%.
LT cash return ratio is the long-term median.
Cash return this year is knocked down a bit because economic growth is stable but below trend.
Small cap earnings are extremely volatile, so we use the median growth rate assuming that that’ll be the result of whatever swing happens. Plus, there isn’t the same base effect to get a +100% eps growth as can happen in recoveries.
FYI the ERP for small caps is usually lower than the S&P 500 because small caps return less cash than large caps. So, investors demand a lower cash return yield from small caps relative to the risk-free rate.
