Opportunities, like troubles, often come all bunched up. Even as the Indian stock markets have been correcting lately, US stock indices have started a fresh bout of declines.
This has led smart investors to ask if they should be bargain-hunting US equities at this juncture. The answer depends on where the US economy and earnings are heading. But macro forecasts can go very wrong and we wouldn’t like to get into them. But we believe this call can be taken based on consensus forecasts and valuations. So here’s our assessment.
Extent of correction
While many Indian investors rushed into US funds when US markets were soaring, a far better time to buy them is when there’s ‘blood on the street’, in Warren Buffett’s colourful words. Today, US stock markets are officially in bear territory. The broad market S&P 500 Index which peaked at 4818 levels in January 2022, has fallen 22.9% from that peak to trade at 3700 levels (as of September 29). The tech-heavy Nasdaq 100, the front-runner of the Covid bull run, is down 31.5% from its peak of 16764 and hovers at 11,490 levels. The manufacturing-heavy DJIA is down just short of 20% from its peak of 36952 and trades at 29680 levels.
For perspective, during the dotcom bubble burst, the S&P 500 fell 25% from peak to trough. During the Global Financial Crisis, it fell 49% between October 2007 and March 2009. During the short but brutal crash just after the onset of Covid, it crashed 32% in March 2020, only to rebound swiftly.
Compared to these occasions, there’s not much blood on the street now. In this year and the next, US equity investors also need to budget for the Fed hiking rates further, unwinding its balance sheet and a recession in GDP. Therefore, we can safely assume further declines in US equities are on the cards.
Where US macros are headed
The current stock market correction in the US has three main macro triggers – inflation, interest rates and the growth outlook. So it’s useful to see where these variables stand and where they’re expected to go.
Persistently high US inflation provided the first trigger for this correction, as it made it impossible for the US Fed to continue with its easy money policies. US Personal Consumption Expenditure (PCE) Inflation which was at 5% in October 2021 picked up to 6.1% by January 2022 and soared to 6.8% by June 2022 before abating a bit to 6.3% by August. CPI inflation readings for this period headed even higher to 8-9%. It was this runaway inflation that prompted the US Fed to rethink its near zero interest rates and QE policies from the beginning of this year. In its recent monetary policy reviews, the Fed has repeatedly reiterated that it will do what it takes to get inflation back to its comfort zone of 2%.
Given that current inflation readings are at 8% plus, this moderation may take time. In the latest September meeting, US Fed Board members forecast that PCE inflation would stay elevated at 5.4% through 2022, moderate to 2.8% by 2023, 2.3% by 2024 and get to 2% only by 2025.(https://www.federalreserve.gov/monetarypolicy/files/fomcprojtabl20220921.pdf)
Private forecasters like The Conference Board seem to believe that the cool-off in US inflation will take longer, with its prediction at 5.8% for 2022 and 3% for 2023. If these inflation trajectories come good, the US Fed will need to remain on a tightening spree until the end of 2023 at least, allowing for its policy actions to flow through with a lag to quell inflation.
#2 Interest rates
Higher interest rates are an automatic trigger to stock price falls because they reduce company earnings and set a higher bar on equity returns, de-rating valuations. In the past three policy meetings, the US Fed has consistently hiked its Fed Funds Target Rate by 75 basis points, a higher level than markets expected. After this hiking spree, the Fed Funds rate has moved from 0.25% in January 2022 to 3.25% now. The effective fed funds rate (the equivalent of India’s repo rate) has moved from 0.08% in January to over 3% now. But the Fed is far from done yet.
In the recent September meeting, Fed members forecast that they expect the Fed Funds rate to average 4.4% in 2022 and 4.6% in 2023, before receding to 3.9% in 2024 and 2.9% by 2025. This suggests that the peak of the US rate hiking cycle will be reached only next year. Market interest rates usually factor in when the Fed moves much ahead of the event and have moved up already. US 1-year treasury yields spiked to 4.1% on September 23, 2022 and have since cooled a bit. But the interest rate environment promises to remain hostile to equities until 2023 at least.
Interest rates aside, an even bigger threat to US (and global) stock valuations arises from the Fed deciding to not just stop QE, but to reverse it to quell inflation. Today, thanks to over 15 years of QE, the Fed is sitting on an $8.8 trillion balance sheet. Should the Fed decide to sell bonds off its balance sheet to restore it to pre Covid levels, that can vacuum up a substantial part of not just US but also global financial market liquidity, posing a threat to all financial assets including bonds and equities. As the Fed balance sheet was at $4.3 trillion just before Covid, that’s a lot of liquidity that could flood out of financial markets, causing mayhem.
#3 GDP growth
Slowing economic activity is obviously a negative for equities because slower growth, or recession impact demand and thus corporate revenues and earnings. Two sequential quarters of falling GDP are reckoned to be a technical recession. The US economy by this yardstick already reported a recession in Q1 and Q2 of 2022, with the GDP sequentially shrinking by 1.6% and 0.6% respectively. But year-on-year growth, at 3.5% and 1.7% was respectable with consumer spending and job markets displaying strength.
Forecasters now expect a mild improvement in GDP in Q3, while predicting a return to ‘recession’ in Q4 2022 and Q1 2023. As a result, Fed members expect US’ overall real GDP growth at 0.2% in 2022, going up to 1.2% in 2023 and 1.7% in 2024, before stabilising at 1.8% in 2025 and thereafter. Therefore, if inflation behaves and the Fed sticks to its current plans, the recession threat may be over and done with by this year and the next.
To summarise, if the macro variables do play out in line with the above predictions, we can expect:
- US inflation to peak out by the current quarter, but stay above Fed’s comfort zone until 2024
- The Fed to hike rates until end 2023, until the Fed Funds rate hits 4.6%
- The Fed to sell bonds and suck out liquidity from US and global markets beginning this year
- A mild US recession to play out by Q1 2023, with a slow recovery thereafter
This tells us why the road for US equities is likely to be rocky over this year and the next. We should expect the US stock indices to continue with their two-way moves, because as each of these macro variables surprise or disappoint, market reactions are likely to be sharp. This suggests that Indian investors may get many opportunities to bottom-fish US stocks over this year and the next. There is no hurry to take all your US exposure right away.
Earnings and Valuations
Stock markets tend to price in events much before they happen. Therefore, with all the above information in the public domain, the question is if US stock indices, by tumbling 20-31% in the past year, have already discounted them.
The best way to gauge this is to see where US indices stand relative to their own historical valuation levels. Taking stock of PEs of the key indices, today’s valuations based on current earnings, are certainly not sky-high.
In fact, valuations have corrected very materially from super-heated levels of a year ago. Unlike narrower indices such as the Nasdaq100 or DJIA, the US S&P 500 is a broad market index with good cross representation across sectors. On a trailing PE basis this index is today trading quite close to its 10-year average of about 18 times. While this would suggest limited downside, the problem is that this 10-year average is in itself influenced by the low-rate-and- excess-liquidity effect.
This makes forward PE a more useful guide to gauging if US markets represent a value buy. Going by current consensus estimates, this is where S&P 500 earnings stand on a forward basis. The forward PE of 15.2 times suggests that a good part of the valuation de-rating is already in the price.
Now, studies looking at the history of US markets over 20-30 years (before Covid and QE) tell us that US indices have tended to bottom out at forward PEs of 13-15 times during past bear episodes triggered by the dotcom bubble burst, GFC and 9/11 attacks. Two useful articles here:
This would suggest that current levels at 15 times forward earnings are not a bad level to buy into US markets, via the S&P 500. But that valuation could easily spike up, if the ‘forward’ earnings for 2022 or even 2023 fail to materialise. Currently, most US analysts don’t seem to be seeing a big earnings collapse, even if recession comes by. This is based on the fact that, while US macros have gotten steadily worse in recent times, US companies have so far delivered relatively strong earnings. (For perspective, S&P 500 earnings grew at a 10.3% CAGR over the last 3 years, 11.6% over 5 years and 7.8% over 10 years.)
The aggregate dollar earnings of the US S&P 500 companies today stand at about $205 on a trailing 12-month basis. They were up by 23% over last year, as the Covid unlock propped up sales. But it is moot if the 10.2% growth in EPS by end of 2022 and a further 7.07% growth by 2023 can materialise if Fed’s rate hikes (and liquidity mopping) hit the mortgage markets and consumer spending, in turn affecting demand and job creation. Should recession turn out to be deeper or more prolonged than expected, that would lead to earnings cuts too. Here’s a simple scenario analysis of where the index could bottom out based on fundamentals, should the following situations play out on earnings.
The answer to the question we raised at the beginning:
- With the S&P 500 (at 3700) trading at about 15 times forward earnings, this is not a bad time to start nibbling in US equities.
- But do not deploy all your money at once, as the next one year is crowded with adverse macroeconomic events. Plus, at the current PE, the US market is building in an optimistic view on earnings
- Budgeting for the economy or the earnings picture turning worse before it gets better, S&P 500 levels of between 2900-3400 could be good for fundamental investors to add exposure.
- Whether it is in terms of growth outlook, inflation or central bank hawkishness, Indian equities today have better prospects than the US. Therefore, use US equities purely to benefit from the stronger dollar (which gains from Fed hikes and the flight to safety) and to invest in sectors/companies that have no parallels in India. Restrict the US exposure to 10-15% of your portfolio. Refer our article here for your choice of funds.
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