Central banks have been aggressively hiking rates in an effort to cool inflation, which is raising concerns the global economy could be in for a potential hard landing. Greg Bonnell speaks with Justin Flowerday, Head of Public Equities at TD Asset Management, about the impact on corporate earnings going forward.
Greg Bonnell: As we approach corporate earnings season once again, plenty of fears in the market about the potential for a so-called earnings recession. Of course, that as the economy slows. Joining us now for more, Justin Flowerday, Head of Public Equities at TD Asset Management.
Justin, great to have you on the program. Seems strange to start the conversation here on another update, but there are concerns in the market about what earnings are going to look like.
Justin Flowerday: Yeah, there are, and I think it’s really important to take a step back and think about where we came from. And we came from a really good place and earnings have been really, really resilient. They’ve been resilient on the back of higher energy prices, which is providing huge amounts of cash flow and earnings for the energy sector.
That’s provided support for the broader market earnings. We’ve seen companies do a pretty good job managing costs, and that’s been supportive. And then the really great companies out there have been able to pass on higher input costs in the form of higher prices to the customers.
And so that’s provided a nice, steady earnings flow from here. Going forward, it’s going to be tougher, and we’ve seen the early signs of some cracks in the market. And you’ve seen PMIs roll over across the world, and we got a data point recently where PMIs were weaker in the US. And we started to hear some announcements from companies that are talking about things getting a little more difficult.
Greg Bonnell: A little more difficult. So let’s dig into that. As we go through this earnings season, obviously – I mean, companies will earn their way depending on what they show us. But are all the storm clouds that are gathering on the horizon, in terms of economic slowdown, in terms of recession, in terms about slaying inflation, just going to weigh in the longer term?
Justin Flowerday: Yeah, I mean it’s – I think what’s happening is you had that summer rally, and that summer rally took away some of the edge for companies who were thinking, this is getting bad. We need to do something. And it allowed them to take some time and say, you know what, maybe things aren’t as bad.And it turns out, obviously, that rally dissipated, and we had a big sell-off.
And I think going into the end of the year, you’ve got all the incentives for companies and management teams to go out there and talk about, look. We’re seeing a challenging environment. 2023 – as we’re providing guidance and updates for 2023 – is not going to look like 2022.
And we can start to begin to see the market take down expectations to a more reasonable level.
Greg Bonnell: Now I understand that your team’s done some interesting work on the relationship between stocks and inflation, because of course that has been the key concern all year – inflation, and what the central banks are going to do to try to slay it.
Justin Flowerday: Sure, yeah. No, we did a little study recently, because you hear a lot about, you know, inflation is really bad for asset returns and really bad for the economy, and we just wanted to put some facts around it. And it turns out inflation, if it’s high and sustainably high, is not good for stocks and bond returns.
And you’ll see some negative real rates return if we’re in a 6%, 7%, 8%, 9%, 10% inflation environment for a prolonged period of time. Deflation – obviously not good. The sweet spot was 1% to 2 and 1/2% inflation. That’s when equities do the best, and that’s kind of where we’ve been living for the last decade or so.
And then this last one, which is moderately higher inflation – 2 and 1/2% to 4% inflation – it was interesting because you saw stock returns of around 10% or a little under 10% in that environment, and bond returns of over 7%.
So moderately higher inflation, which is where we think we’re going to live for the next five years as the fed starts to crack the labor market and take some pressure off the economy. We think we’ll be in that 2 and 1/2% to 4% range. It’s not a bad world for stocks and bonds.
Greg Bonnell: Not a bad world for stocks and bonds. That’s what we like to hear longer term as well. All of this volatility that we’ve seen – you get the summer rally, you get a sell-off on the back of that. September was miserable.
Thank God September is over, from an investor’s point of view, even though the weather’s getting colder. Then you get a rally again. I mean, when you step back and sort of just try to take a breather from the day-to-day, how should we be thinking about the market?
Justin Flowerday: Yeah, a few different things. I’ve talked about earnings. I mean, you have to always think about what does valuation look like? If you’re ever making a buying decision to either buy the broader market or buy individual stocks, what’s the valuation set up? And when you think about that, we started the year at over 20 times earnings for the broader market in the US. It may have been 22 times earnings in January.
We’ve come down now to 16 and 1/2 times earnings, and so that’s a more reasonable entry point and probably more in line with historical averages. So you’re not going to see, necessarily, a valuation headwind from here. Probably not a tailwind, either.
And then the other way to look at it is stocks versus other asset classes. And one of the tools that we use to gauge how attractive that is is the equity risk premium, which essentially says you can invest in a guaranteed rate of return – T-bill – or you can invest in equities, which have, obviously, an uncertain rate of return.
And how much are you going to get compensated above T-bills for buying equities? And over time, you get a sense of what a fair equity risk premium is. And right now, our equity risk premium is about 2.75%. Kind of in line with long-term averages. Again, not really that much of a headwind, and I don’t think that much of a tailwind, either.
Greg Bonnell: Now of course, when we talk about the storm clouds on the horizon, this is the idea that as the central banks try to bring inflation under control, they’re going to tip us into recession. First it was like, oh, it’ll be a soft landing, a hard landing, can we escape a recession?
People are pretty negative on the space. So if we did end up in a recession, what does it look like, what are the chances, and how are we supposed to handle that as investors?
Justin Flowerday: Yeah, so if we end up in a recession, I think we have to understand that, for companies that we invest in, their earnings aren’t going to grow if we’re in a recession. So their earnings will probably be down on a year-over-year basis. And so we need to have a reset of expectations.
And I mean, essentially the fed told us that they want to send us into a mild recession. They’re trying to make a nice balance there of avoiding a deep recession, obviously. And if we get earnings estimates coming down, and come down from, let’s say, $225, down to $215 for the S&P 500, that’s OK.
What we don’t want to see, is we don’t want to see the types of things we saw in 2007, 2008, or 2001, where you saw earnings really, really come down a lot. And we think there’s support for earnings to come down, but there’s support for them not to get completely destroyed.
So look, for us, it’s a lot about earnings. And I think the other thing we got to realize is a lot of the pain has been felt. We’re down for the year now. NASDAQ’s 30% off from the beginning of the year. The S&P 500 is below 20% off from the beginning of the year. So the market has anticipated some of what we’re going to see in terms of earnings declines next year.
Greg Bonnell: In terms of how to handle that environment, it sounds like we need to be nimble.
Justin Flowerday: Yes.
Greg Bonnell: If you just sort of say, I think this is going to happen, and just ignore everything from this period on, you’re probably not going to be in a good place.
Justin Flowerday: No, absolutely. And I will say, also, that there is going to be some companies that are not going to survive and aren’t going to do as well because they’ve been receiving capital essentially for free for the last 5, 10 years. And liquidity is going to dry up.
And so for us, what we’re doing is we’re spending a lot of time looking at quality, and evaluating the companies that are going to be able to gain share throughout the next one, two, three years during a difficult environment, and companies that are going to have pricing power.
But it’s going to be really important to avoid those companies that are going to – the funding is going to dry up, and some of those companies aren’t going to survive. And that can lead to a destruction of wealth that you’re going to want to avoid.
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