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Weekly Investment Commentary: U.S. equity allocations amid earnings and economic uncertainty
Bottom line up top:
- Will one recession end as another begins? Whichever optimist came up with “When one door closes, another one opens” didn’t have earnings and economic recessions in mind. But with third quarter earnings season underway, many investors hope earnings growth for S&P 500 companies will be back in positive territory after three consecutive quarters of decline. If that happens, the door will close on the earnings recession — and unlike in the old aphorism, this closed door is a good thing. As of 06 Oct, current blended earnings growth estimates for the S&P 500 are only modestly negative (-0.3%). The bad news is concentrated in the energy sector, which is still contending with base effects from strong earnings growth in 2022 (Figure 1).
The current U.S. earnings recession is one of the few that did not coincide with a recession in the broad economy. On the other hand, the U.S. has never experienced an economic recession that did not include at least two consecutive quarters of negative earnings growth. This relationship between earnings and economic recessions warrants caution, as our base case outlook still calls for the economy to contract, albeit mildly, sometime in 2024. This is another door opening, but in this case to an economic recession. - Margins may hold the key to the door. Although earnings have shown some improvement, and at the broad index level are largely in line with longer-term averages, deciding on specific equity allocations isn’t an open-and-shut case. But high-quality cash flows and defensible margins are a good place to start, as companies with these characteristics typically outperform during recessionary periods.
“Deciding on specific equity allocations isn’t an open-and-shut case.”
Portfolio considerations
Thanks in large part to this year’s U.S. equity market rally, the S&P 500 Index’s price/earnings (P/E) multiple has expanded by 6.8% in 2023 through September (based on 12-month forward earnings). The S&P 500 returned 13.1% during this period, with earnings growth expectations up 4.1% (Figure 2). The resulting P/E ratio for the index is 17.9x earnings — in line with its 10- year average. While we have a neutral view on equities, our economic outlook calls for a slowdown over the coming quarters. With that in mind, and with corporate earnings season underway, we’re especially mindful about where we want to allocate equity risk.
From a sector perspective, we’re optimistic on information technology and health care. Tech stocks have strongly outperformed the broader market year-to-date, driven by the largest names. And their soaring share prices have been accompanied by a dramatic advantage in earnings before interest and taxes (EBIT). Within technology, we remain constructive on less-cyclical select software companies — specifically those whose revenue sources are tilted toward enterprises rather than retail consumers. Such companies tend to have resilient business models and inelastic demand.
Health care is a defensive play with the potential to outperform if the economic slowdown that we expect materializes. The sector has seen its share of consumer spending expand, largely a function of higher outlays for Affordable Care Act (ACA) expenses (12% growth in 2022 and 35% growth over the past two years).
Our view on the energy sector is neutral. Energy has been in the news lately, with the daily spot price for West Texas crude oil surging 29% in the third quarter, approaching $95/barrel in late September before settling slightly below $91. But we believe further upside in oil prices is limited, and gasoline margins have peaked seasonally. On a positive note, corporate balance sheets have undergone massive repairs coming out of Covid, when equity market caps were 85% of the benchmark’s enterprise value. With debt no longer a headwind, energy companies are engaging in share buybacks and paying both regular and special dividends. Upstream energy companies (those involved in exploration and production) will likely see positive earnings revisions, as the longer-dated oil curve moved meaningfully higher over the past few months.
We remain less optimistic on financials. Banks are facing regulatory pressures on capital liquidity, as well as increased competition for customer deposits. Tighter lending standards are also weighing on the banking industry, and net interest margins are under pressure.
“With our expectations of an economic slowdown over the coming quarters, we are mindful on where we are allocating equity risk.”
Nuveen’s Global Investment Committee (GIC) brings together the most senior investors from across our platform of core and specialist capabilities, including all public and private markets.
Regular meetings of the GIC lead to published outlooks that offer:
- macro and asset class views that gain consensus among our investors
- insights from thematic “deep dive” discussions by the GIC and guest experts (markets, risk, geopolitics, demographics, etc.)
- guidance on how to turn our insights into action via regular commentary and communications
Endnotes
Sources
All market and economic data from Bloomberg, FactSet and Morningstar.
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