Has US equities priced in recession?
Regarding the US equity market, our current key observations are: (1) apart from tech and tech-related sectors, the drawdown this year has been fairly moderate at the sector level, (2) valuations have been corrected more broadly, but (3) consensus earnings remain close to record highs for various sectors, with earnings of cyclical, energy and banks being particularly vulnerable if the economic downturn accelerates, which would be in line with our macro base case.
Upfront, it should be noted that our fundamental view on the market has not changed. We still believe that equities are not yet priced for the deceleration in macro data, which will likely unfold over the coming 12 months. While the market correction has been quite pronounced so far, it is still less severe than it was during past major downturns. Valuations have been corrected in line with previous recessions, but earnings expectations have not yet been reacted. As the economy continues to slow, and reported earnings are set to disappoint somewhat, consensus downgrades are likely to follow.
We have looked at the peak-to-trough levels from around the dates at which the market started to sell off, but individual sector peaks and troughs may still lie weeks apart. For example energy, which has had an exceptional run in 2022, only peaked at the beginning of June and has been corrected by 24% since then. This is significant, yet well below the pull- backs the sector saw during recessions in which demand dried up and oil prices fell sharply (2008 and 2020). For most other sectors the same trend holds, with the drawdown in 2022 [to date] being substantially below previous downturns. In most cases, only the shallow recession in 1990 is in the same range, while other recessions have seen more pronounced sector pullbacks.
The sectors which stand out are tech-heavy sectors, such as tech, consumer discretionary and communication services, all of which have already seen more pronounced downturns than in two out of the last four recessions. Admittedly, they have come from elevated valuations, but these have also been adjusted more than in most other sectors, while their consensus earnings numbers have already seen at least some downgrades.
Assumptions of earnings in most other sectors are still at or only slightly below record highs. Healthcare in particular stands out with downgrades as severe as in 2008, while the sector saw no downgrades at all during the recessions in 1990 and 2001. More interesting is the fact that the recession-sensitive sectors such as energy, financials and the cyclical segment of the market have pretty much yet to see adjustment to earnings expectations. It’s not unusual to see the market top out well ahead of the peak in earnings and bottom out well before the trough in earnings, but it would be unprecedented for the market to reach bottom before downgrades kick in. In combination with the current relatively moderate valuation de-ratings, the point at which a recession would be priced across sectors still appears to be some time off.
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