Welcome to RBC’s Markets in Motion podcast, recorded February 28th, 2023. I’m Lori Calvasina, head of US equity strategy at RBC Capital Markets. Please listen to the end of this podcast for important disclaimers.
Today in the podcast, a refresh of our 2023 outlook. The three big things you need to know: First, we’re sticking with our 4,100 YE 2023 S&P 500 target. We continue to view 2023 as another year of messy post-crisis normalization, similar to the 2010-2011 and 2002-2003 periods. Second, we see a relatively balanced risk/reward between Growth and Value for the balance of the year, though Growth is likely to bear the brunt of renewed inflation/Fed fears in the very near-term. Third, we continue to prefer Small Caps to Large Caps, though we admit that the setup for Small Caps is less compelling than it was last July when we turned overweight Small Caps.
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Takeaway #1: We’re sticking with our year end 2023 S&P 500 price target of 4,100.
Our forecast is unchanged since we introduced it last October and is roughly the average of six different models. Our most optimistic test puts the index at just over 4,400 and our least optimistic test puts the index at just over 3,800. Overall, the range of outcomes is a little lower than our last update.
Generally, we are looking for 2023 to be one of very modest gains in the S&P 500 and see the year as part of the messy post-crisis normalization that investors must endure, similar to 2002-2003 and 2010-2011. Until recently, the S&P 500 in 2022-2023 has been tightly correlated with the 02-03 path, which suggests that a pullback that does not break below the October lows is overdue.
We think the path to 4,100 is likely to be bumpy as earnings forecasts are cut, the moderation in inflation proves to be uneven, investors await a transition in Fed policy (stocks often fall ahead of final hikes),
And as investors digest the onset of a challenging economy (the median return for the S&P 500 has been 0% in years where real GDP is in the 0-2% range, as current consensus forecasts are anticipating).
Key challenges that we see include ongoing angst over inflation and Fed policy, debate over whether a recession will emerge in 2024 (we think it’s too early to have visibility here), the debt ceiling (typically a problem in the summer and fall), and the geopolitical backdrop for both China and Russia/Ukraine.
We remain less worried about the impact of falling 2023 EPS forecasts on stock market performance than other strategists, given that stock prices tend to bottom 3-6 months before positive EPS revisions return,
and that in downgrade cycles most cuts tend to happen by April. Buyside expectations have been lower than sellside expectations for quite some time (several told us last year they were anticipating $205-$210 as opposed to the sell side’s current forecast of $223).
Our work also suggests that last year’s price declines in the S&P 500 already baked in considerable earnings challenges for 2023.
The idea that stocks no longer look attractive relative to bonds is a drag on our forecast, as is the idea that the 4Q22 midterm rally in the S&P 500 pulled forward some of 2023’s gains.
Money flows are also favoring non-US equities over domestic equities, but it’s worth noting that US valuations are looking less problematic relative to Europe again.
All that being said, the sentiment set up has been positive. Retail investors came into the year deeply bearish on the AAII survey, a bit worse than pandemic lows and at levels that in the past have been followed by a 15% 12-month forward gain in the S&P 500 in the past. A recovery has started here, but is only middle innings.
And even with the recent move up in inflation and Fed Funds expectations, our valuation model – based on data back to the 60’s and which is baking in 3% inflation, 3.5% on the 10 year, and 5% on Fed funds at YE 2023 – still makes the case for some modest multiple expansion this year.
Overall, we feel neutral on the stock market from here through year end with our forecast calling for a little upside. Not the most exciting call to be sure, but one that we feel is the right way to think about things.
Moving on to Takeaway #2: We See A Balanced Risk/Reward Between Large Cap Growth And Value Through Year-End, Despite Incremental Pressure on Growth Near-Term From renewed Fed and inflation fears.
Arguments that we currently see in favor of Value include:
- Value looks a little better from a balance sheet perspective, with receding short term and long term debt levels.
- Growth has turned slightly expensive relative to Value again, with the Growth/Value relative P/E now slightly above its long-term average as of mid-February. This is a change from the end of last year when the Growth/Value P/E ratio was sitting at its long term average.
- Major crises tend to usher in shifts in leadership between Growth and Value. Coming out of the Tech bubble, leadership shifted from Growth to Value.
Meanwhile, arguments that we see in favor of Growth include:
- Earnings revisions trends have turned a little stronger in Growth than Value.
- Growth has a bit more international exposure than Value, at least within Large Cap, and has benefited from renewed interest in international markets and the weakening Dollar.
- Historically, when economic growth has been sluggish, Growth stocks outperform Value stocks. We continue to think that sluggish economic growth is the price we will pay for a short, shallow, or barely averted recession in 2023.
Admittedly, in the end this trade may come down to the ultimately direction of 10 year yields.
Wrapping up with Takeaway #3: We Continue To Prefer Small Caps To Large Caps, But Admit that the set up is less favorable than it was when we upgraded Small Caps to overweight last July.
Beyond the likelihood that the Russell 2000 is likely to hold up better than the S&P 500 in the short term as Large Cap Growth comes under pressure again due to inflation and Fed fears, here’s why we still see opportunity in Small Caps today:
- Valuations still look appealing for Small Caps relative to Large Caps…
- And Small Caps still have room to run on their own P/E which is only back to the long-term average after hitting typical troughs last summer.
- Money flows have been more favorable for Small Cap to start the year.
- Tighter high yield spreads have supported the Small Cap trade.
Here’s why we think the setup for Small Caps isn’t quite as strong as it was last summer:
- Earnings revisions are no longer stronger in Small Cap than Large Cap – we think is largely due to less US Dollar pressure on large cap earnings.
- There’s less interest in US domestic markets as interest in international markets has picked up.
- Small Caps have started to bake in an economic recovery early, unlike last summer when they were baking in today’s economic challenges. To the extent 2024 recession concerns spike, small caps could be at risk.
That’s all for now. Thanks for listening. And be sure to reach out to your RBC representative with any questions.