The consensus economic outlook for 2023 is gloomy with predications of a recession within the next 12-months almost unanimous. A Wall Street Journal poll of business and academic economists placed the probability of a recession within 12-months at 61%, a relatively high recession probability outside of an actual recession[1]. The Federal Reserve Bank of New York recession probability model estimates the probability of a recession twelve-months ahead is 47.3%, a reading above 30% has generally been associated with a recession[2]. A recession in 2023 seems more probable than not.
Chart. Federal Reserve Bank of New York – Probability of US Recession Predicted by Treasury Spread
Sources: Board of Governors of the Federal Reserve; National Bureau of Economic Research; authors’ calculations.
Yet, despite the pessimistic outlook, analysts estimate corporate earnings will increase 4.2% over the next 12-months[3]. Analysts have been revising earnings estimates down since September 30 and are now predicting earnings to show negative year over year growth for the fourth quarter of 2022 and the first half of 2023. Based on signals from the yield-curve, additional revisions to lower earnings estimates may be warranted.
Economists and market strategists closely monitor the yield-curve due to its strong track record of predicting future recessions. The yield-curve represents the interest rates for similar types of bonds at different maturities. It is normally upward sloping as longer duration bonds of the same credit offer higher interest rates relative to shorter duration maturities to account for the longer holding period risk. Shorter duration maturities tend to be affected by bank policies such as the Federal Reserve monetary policy, while longer duration maturities reflect investor expectations for inflation and growth. If the yield spread between the longer duration and shorter duration treasury is negative, it is considered a “yield-curve inversion.” In this scenario the yield-curve would be downward sloping meaning the shorter duration has a higher yield relative to the longer duration maturity. A yield-curve inversion reflects investor expectations that longer-term rates will decline due to deteriorating economic conditions, and anticipation the Federal Reserve will reduce interest rates to provide monetary accommodation.
One of the most followed yield-curve spreads is the 10-year treasury bill compared to the 3-month treasury note. A protracted 10Y-3M treasury yield-curve inversion has been a reliable recession signal[4]. Since 1970, the economy has experienced eight recessions and the 10Y-3M treasury yield curve inverted prior to each one. The 10Y-3M treasury yield-curve inverted in October and the spread is currently -1.24 (as of 1/20/23), the deepest inversion in 40 years[5].
The spread on the 10Y-3M yield-curve has a strong directional relationship with corporate earnings. As the spread tightens and inverts, earnings tend to decline. If the spread widens, earnings likely increase as longer-term interest rates rise to account for expected higher long-term growth. Jim Paulsen from Leuthold Group did an analysis on the relationship between the 10Y-3M yield-curve and earnings. Since 1963, earnings have experienced nine major retrenchments and all but one (1986-1987) was preceded by a yield curve inversion[6]. Given the extent of the yield-curve inversion, there is a strong case for earnings in 2023 to be under pressure due to a softening economy.
If stock prices represent the future earnings power of companies and earnings are expected to be revised downwards this year due to a recession, what does that mean for stock market performance? Can earnings fall and stocks still rise? The chart below from LPL Research illustrates S&P 500 earnings growth versus price performance. The chart demonstrates that stocks can still have positive performance when earnings decline. In fact, when earnings fall, stocks are more than twice as likely to be positive[7].
Chart. S&P 500 Annual Earnings Growth vs Price Performance
Additionally, FS Insight research suggests earnings are not a determining factor in equity returns. When S&P 500 earnings are negative for 12-months, the average return over that same period is 6.8%. When earnings are positive, the average return over the same 12-month period is 9.6%. Performance improves for negative earnings years to 11.5% when the prior 12-month price return is negative[8]. If earnings in 2023 decline, it doesn’t necessarily mean the market will follow. Equity markets could still have a positive year despite the drag of negative earnings.
Over the past year, the market has had to absorb several headwinds: highest inflation in forty-years, Federal Reserve interest rate hiking cycle, supply chain disruptions, foreign currency exchange pressures, China zero-Covid policy and Russian aggression in Ukraine. Some of these headwinds in 2022 may turn to tailwinds in 2023 and help support the market.
- Inflation – Inflation data and reports are showing that inflation has peaked and could noticeably fall over the next year. This will reduce cost pressures on both manufacturers and consumers.
- Federal Reserve Rate Hikes – The Federal Reserve is likely to stop raising rates in 2023. This will remove a cloud of uncertainty related to the terminal rate level for the Fed Funds Rate. The lack of confidence in the direction of interest rates has been a drag on fixed income and equity markets.
- Easing US dollar – After rising for most of 2022, the US dollar has been easing since October which could help provide a boost in earnings for multinational corporations.
- China reopening – China reopening from their zero-Covid lockdown policies could spur demand and further ease supply chain issues.
Ultimately, earnings go through troughs and recoveries. Earnings may need to be revised down further this year as corporations steer through a slowing economy. The market is a forward pricing mechanism and may opt to see past the issues plaguing the economy if a recovery is expected. While the economy and corporate earnings may find growth difficult this year, it doesn’t necessarily mean the stock market has to experience a similar outcome.
[1] Torry, H & DeBarros, A. (2023, January 15). ‘Economists in WSJ Survey Still See Recession This Year Despite Easing Inflation.’ Wall Street Journal. https://www.wsj.com/articles/despite-easing-price-pressures-economists-in-wsj-survey-still-see-recession-this-year-11673723571
[2] Federal Reserve Bank of New York, The Yield Curve as a Leading Indicator, https://www.newyorkfed.org/research/capital_markets/ycfaq.html
[3] Butters, John. Earnings Insight. FactSet. January 20, 2023; https://advantage.factset.com/hubfs/Website/Resources%20Section/Research%20Desk/Earnings%20Insight/EarningsInsight_012023.pdf
[4] Estrella, A., & Mishkin, F. S. (1996). The yield curve as a predictor of U.S. recessions. SSRN Electronic Journal. https://www.newyorkfed.org/medialibrary/media/research/current_issues/ci2-7.pdf
[5] Federal Reserve Bank of St. Louis, 10-Year Treasury Constant Maturity Minus 3-Month Treasury Constant Maturity [T10Y3M], retrieved from FRED, Federal Reserve Bank of St. Louis; https://fred.stlouisfed.org/series/T10Y3M, January 22, 2023
[6] Paulsen, J. (2022, October 10). “Is The “Death” Of Profits Greatly Exaggerated?” Paulsen’s Perspective. https://advisors.leutholdgroup.com/research/paulsen/2022/10/10/is-the-death-of-profits-greatly-exaggerated.23880
[7] Buchbinder, J. (2023 January 19). “Earning Down, Stocks Up? Not as Uncommon as You Think.” LPL Research – Macro. Market. Movers. https://lplresearch.com/2023/01/19/earning-down-stocks-up-not-as-uncommon-as-you-think/
[8] Lee, T. (2023, January 6). "maths" show probability of 2023 seeing >20% far higher than expected (53%). VIX key for 2023 returns, not EPS growth and 3 catalysts likely to make "opportunity" less "crisis". FS Insight- First Word.
The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. All performance referenced is historical and is no guarantee of future results. All indices are unmanaged and may not be invested into directly.
The economic forecasts set forth in this material may not develop as predicted and there can be no guarantee that strategies promoted will be successful.