The bear market in equities won’t be over “until recession arrives or the risk of one is extinguished.”
That’s according to Morgan Stanley’s Mike Wilson who, on Tuesday, said that although stocks have de-rated and are “more fairly priced” for a deceleration in corporate profit growth, equities aren’t priced for a recession.
Opinions vary on this point, mostly because, as noted here last week, much depends on what you mean by “priced.” There are any number of ways you could go about claiming stocks are anticipating a downturn and vice versa.
Wilson compared max recession drawdowns across sectors and industries to 2022’s selloff (figure below). Consumer Discretionary and Food & Staples Retailing are very close to matching the average drawdown from the last three recessions, but most other sectors are some way off.
More generally, equities are around 60% of the way there, Wilson said, noting that this year’s price action is “relatively similar to recent recessions in terms of leadership.”
Panning out, Wilson suggested the index multiple has scope to contract further. While some on the Street now expect multiple expansion in order to goal seek or avoid cutting year-end S&P targets, Wilson said Tuesday that “today’s 15.3x P/E incorporates an equity risk premium of just 330bps, which is too low, in our view, given the rising risks to growth.” If you want a “more comfortable” ERP of 370bps or higher, stocks could de-rate another full turn to 14x “assuming Treasury yields and earnings estimates remain stable,” he added.
Of course, those latter two assumptions aren’t safe. Treasury yields have been the furthest thing from “stable” in 2022, and the risks from here are two-way (lower in a recession scenario, but with a tail risk of a disorderly bear steepener if the Fed loses control of inflation expectations). As for earnings, I’ve repeatedly argued that corporate America is due for a profit reckoning as margin headwinds collide with a stretched consumer.
Wilson was very vocal earlier this year in warning on risks to corporate profits. He was also very early (as chief equity strategists go) in cautioning on the risk of an inflation overshoot and an aggressive Fed pivot.
“At this point, a recession is no longer just a tail risk given the Fed’s predicament with inflation,” he said, reminding investors that part and parcel of the bank’s framework for assessing US equities was the notion that “the Fed [has] to tighten into a slowdown, or worse.”
Although officials have been careful to avoid spelling out the ramifications of their unfolding pivot in caustic terms, they’re becoming more explicit. “I don’t care what’s causing inflation, it’s too high,” Christopher Waller said over the long holiday weekend in the US. “It’s my job to get it down [and] higher rates [will] put downward pressure on demand across all sectors.”
Morgan Stanley’s bear case for the second half of this year and the first half of 2023 “always assumed a recession outcome,” Wilson noted. Previously, the bank put the odds of a downturn at around 20%. Now, those odds are “closer to 35%,” Wilson remarked, citing Morgan’s economists. If you ask him, he’d “probably err a bit higher” considering the equity team’s cautious outlook on the US consumer and corporate profits.
Currently, Treasury yields and the bank’s fair value projection for the ERP imply a forward multiple of 14.3x for the S&P. Applying that to consensus bottom-up 2023 EPS gets you to 3,400 on the index (actually a little higher). But that’s not a recession scenario. 2023 EPS won’t be anywhere near current bottom-up consensus next year in a downturn. I’ve suggested on at least three occasions it could be between $180 and $190. Wilson’s bear case is $195. The figure (below) will be familiar to regular readers.
The median LTM S&P earnings decline during post-War downturns was 13%. 2021 S&P EPS was $209. Consensus for this year was around $231 as of late last week.
“Should the risk of recession increase to a point where it becomes the market’s base case, we could envision a combination of 200bps for UST yields and 500bps for ERP… alongside a much lower NTM EPS forecast of something closer to our 2023 bear case forecast of $195,” Wilson said.
The read-through: 3,400, the bank’s near-term downside, doesn’t discount “a full-blown economic recession,” where that means an unemployment cycle. In Morgan Stanley’s view, a recession outcome implies “a much lower trough for the S&P 500 of ~2,900.”