Goldman Cuts S&P Forecast Citing ‘Dramatic’ Fed Shift

Thanks in part to solid fourth quarter results, US equities “found their footing” following a turbulent start to the year, but “signals for the 2022 earnings outlook have been mixed,” Goldman’s David Kostin said, on the way to cutting the bank’s S&P target.

Out of 151 companies that provided guidance, more than half guided below consensus. Further, bottom-up consensus EPS estimates remained unchanged for the index, as did margin forecasts. The macro backdrop, meanwhile, has deteriorated. Specifically, the growth-inflation mix looks considerably less favorable.

Recall that Goldman recently cut their outlook for US growth in Q1, raised their yield forecasts for 2022 and penciled in seven Fed hikes for the year. None of that bodes especially well for equities, especially to the extent real yield-led rate rise is predicated on policy tightening, not an upgraded outlook for growth.

“Given the Fed’s apparent willingness to tighten policy to keep inflation in check, and our economists’ view that there will be an organic decline from current elevated levels in goods inflation and that sequential pressures in certain other core categories may have peaked, we expect the pattern seen thus far this year — of higher real yields and lower inflation breakevens — to persist through the year,” the bank’s Praveen Korapaty wrote this week.

Goldman sees two-year reals jumping almost 100bps. 10-year reals should rise another 30bps, at least, on top of January’s sharp increase (figure on the left, below).

To be sure, the bank doesn’t harbor anything like a dour outlook on the world’s largest economy or corporate profits. Indeed, their EPS target is unchanged at $226 for this year (excluding energy, it’s $3 lower), and higher at $240 for 2023 due to the demise of Build Back Better (no corporate tax hikes next year). Notwithstanding any Q1 weakness, Goldman expects real US GDP growth to average 3.2% in 2022, which implies 11% earnings growth.

Ultimately, though, the Fed outlook and the prospects for higher yields driven by real rates compelled Kostin to cut the bank’s S&P target by 4% to 4,900 (figure on the left, below). “While our index EPS estimates remain unchanged, we adjust our valuation forecast following our economists’ revisions to the path of interest rates,” he wrote.

When Goldman published their year-end 2022 target for the index in November, the bank’s economists had just a pair of rate hikes penciled in, and the rates team saw 10-year nominals ending 2022 at 2%. What a difference three months makes.

“Inflation has been higher than expected and Fed policy outlook has changed dramatically,” Kostin said. “Our economists now expect seven Fed hikes in 2022 [and] our interest rate strategists forecast the nominal 10-year Treasury yield will rise by 33 bps from current level to 2.25%, driven entirely by real yields,” he added, alluding to the calls mentioned above.

This is very simple, even as the situation remains fluid. Over the last half-century, periods defined by solid growth and well-behaved real yields were accompanied by robust equity market performance. Specifically, 12-month returns averaged around 16% (figure on the right, above). A corollary says periods of slower growth and higher real yields are associated with less enthusiastic returns (around 8%).

“Uncertainty abounds regarding the path of inflation and Fed policy,” Kostin said, positing a pair of alternative scenarios. “We believe two-sided risks exist to our baseline S&P 500 forecast, but with a larger downside tail,” he remarked, before noting that the bank’s revised forecast “implies a full-year total return of 4%, modestly below the historical average,” while the new interim three- and six-month targets are 4,500 and 4,700, respectively.