If we’ve learned one thing this year, it is that US equities are not an inflation hedge. The S&P 500 and Russell 2000 are each down 19 percent YTD, and 1-year CPI inflation is running 8 pct. Stock investors have lost more than 25 percent this year on a real, after inflation, basis.
Aggressive Federal Reserve monetary policy and the higher long-term interest rates those bring are one – but only one – reason for this terrible equity market performance. Higher rates this year have reduced equity valuations, just as lower rates boosted price-earnings ratios over the last +30 years. On top of that, markets rightly worry that Fed policy will inevitably cause a recession and reduce corporate earnings. This uncertainty erodes investor confidence and further compresses valuations.
The other, less discussed, part of the story is that corporate earnings are not keeping up with inflation. With 85 percent of the S&P having reported Q3 earnings, the index is only set to show 2 percent earnings growth versus last year. That is far less than 8 percent CPI inflation.
A few sectors, however, are proving they can keep pace with inflation. The FactSet chart below shows Wall Street analysts’ earnings expectations for current quarter (Q4) earnings growth versus last year:
Two points on this data:
- Analysts expect the S&P 500 as a whole to report an earnings decline of 1.0% in Q4. Estimates are still coming down for the current quarter, so this negative comparison is likely to get worse as we go into year end.
- Just 3 sectors – Energy, Industrials, and Real Estate – are expected to show any Q4 earnings growth. Even more importantly, all should have bottom line comps to last year that beat current-quarter inflation.
Looking forward to 2023 expected earnings growth, the following FactSet chart tells the story. If CPI inflation runs 5 percent next year, about half the S&P should be able to show earnings growth better than that level but the other half are expected to fall short. Of the 3 sectors with positive Q4 2022 earnings comps, Industrials look set to continue their inflation-beating earnings performance. Real Estate falls short. Energy is expected to have the weakest earnings comps of any S&P sector, but that assumes commodity prices will be lower than 2022. We think that is too pessimistic.
Takeaway: stocks can only be an inflation hedge if the corporate earnings they discount keep up with rising prices. Most of the S&P is falling short of that target right now, and 2023 is not looking great on this count either. Of the 3 groups we have highlighted in this report, we like Energy the most. It is the cheapest sector in the S&P by far (10x forward year expected earnings), its earnings growth is beating inflation right now, and 2023 estimates look too low to us based on still-high commodity prices.