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The stock market is at a point of inflection where there are a range of possible outcomes.
In the 13 recessions since World War II, U.S. gross domestic product (GDP) suffered a median decline of 2.6% and the unemployment rate rose by 3.6% points. It is reasonable to assume that the next recession will be relatively mild. Household and corporate balance sheets are in good shape. Aside from inflation, there are no significant obvious economic imbalances. The risk with a soft landing that avoids recession is that the unemployment rate doesn’t rise by enough to reduce inflation.
In this scenario, the Fed funds rate could then rise towards 6% and set the scene for a more significant recession and market reaction. The strength of labor market, consumers continuing with their spending, and inflation trajectory will play key roles in determining how much the economy slows in 2023. However, the risk of a deep recession similar to that of 2008 is low.
As of the end of November 2022, forward consensus estimates predicted mid-single-digit growth in Earnings Per Share (EPS) for the U.S. over the following 12 months. Past U.S. recessions typically have resulted in 15% to 20% earnings declines for S&P 500 Index.
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There are three possible U.S. earnings scenarios, the first, reflecting a soft landing, the second, a “normal” recession, and the third, a recession plus a reversal of a 25-year upward trend in U.S. profit margins.
In a soft landing scenario, recent EPS assumptions for the S&P 500 Index appear reasonable but is expected to be revised downwards. A “normal” recession, based on the last four U.S. recessions (not including the 2008–2009 global financial crisis), could see EPS decline by an estimated 15% – 20% over the next 18 months.
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The market is at a point of inflection where there are a range of possible outcomes.
In an upside scenario, inflation cools quickly, the Fed does not need to raise rates much more (if at all), and US economic growth surprises to the upside which leads to S&P 500 EPS growth of 5–6% in 2023. This can lead to potentially double-digit growth in the price of S&P 500 Index.
In a downward scenario, where inflation doesn’t fall or the lagging effect of the Fed on the US economy is too much to bear, S&P 500 EPS are expected to fall below to normal recession level, resulting in further decline in S&P 500.
(Source: Insights on Passive Investment report by Mirae Asset Mutual Fund)