We believe we are early in the process of management teams and market participants revising down earnings expectations for 2023 to reflect the more challenging economic conditions - Franklin Templeton
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This year has proven to be a challenging environment for investors, with surging inflation, supply chain disruptions, war in Europe and volatile energy prices among the factors contributing to heightened uncertainty. Corporate earnings have thus far remained robust, even as inflation has pressured valuations and raised concerns about the outlook for economic growth. Given this backdrop, equity market leadership has changed frequently as investors have struggled to adjust to the impact of higher rates and the possibility of slowing growth. Growth-investing dominated much of the prior market cycle and investors have become accustomed to looking to a narrow group of large-capitalization growth stocks to generate returns. The current environment has reminded investors that market trends and leadership can change abruptly, which should reinforce the importance of maintaining exposure to a balanced portfolio of high-quality holdings that are generating attractive levels of profitability today. In this piece, we will outline our thoughts around the current market environment, as well as the role that dividend growth equities can play in helping investors navigate volatility and achieve their long-term investment goals.
More than inflationary pressures
In some ways, 2021 provided a preview of 2022, as the market oscillated between growth and value styles, and we began to see high-growth leadership stumble. The view of inflation—which has proven to be less transient than initially anticipated—has driven much of the market volatility. At the most basic level, higher inflation has led to the need for the US Federal Reserve (Fed) to raise its federal funds rate, which has put downward pressure on equity markets broadly. We believe that this is a crucial point, because the market’s recent attempts to rally, which have been characterized by brief but powerful performance from early-cycle stocks, leads us to believe that investors may be confounding the impact of inflation with the impact of rising federal funds rates. This is a critical distinction given that monetary policy operates with a significant lag. The current surge in inflation has not only caused market valuations to decline broadly but has also impacted corporate profitability by driving up costs and curbing demand, thereby putting pressure on corporate profit margins. However, we believe that there is likely still pressure on corporate profitability to come, because the impact of inflation on market valuation has driven the market’s correction thus far, rather than the impact of rising interest rates on corporate profitability.
While it is the Fed’s goal to slow the economy enough to bring inflation back down to manageable levels, there is a risk that economic growth slows beyond desired levels. This can cause employment to weaken, which can further erode the economic environment. Monetary policy has historically worked with a material lag before beginning to impact economic conditions and, given that many economic indicators have overall held up reasonably well, we see some risks from investors expecting an “all-clear” from the market imminently as inflation peaks. We are reluctant to try to forecast when inflation might peak and what the pace of retrenchment may be, but we believe that the magnitude of the slowing impulse that the Fed has put into motion to restrain inflation will begin to take a toll on the broader economy over the course of 2023.
While a lot of attention has been dedicated to this inflationary cycle, in our view, there has been less focus on the potential consequences of weakening economic growth and corporate profitability. We are monitoring the overall health of the housing market, as weakness there is typically considered an early indicator of weakening economic growth prospects given the housing market’s particular importance to consumer sentiment. The Case-Schiller Home Price Indexes have moved up sharply since the COVID-19 pandemic, which, combined with the highest national average mortgage rates in more than 20 years, is weighing on residential investment sentiment. Similarly, signs of weakening housing markets can be seen in declining housing starts and permits, mortgage applications and the NAHB Home Builders Market Index. Given that this industry has a reputation as a leading indicator of US recessions, we are watching it closely, and have taken a cautious view on housing-related holdings even as we see long- term opportunities for several companies in the sector.
Corporate profitability has thus far held up relatively well, though we note the Purchasing Managers’ Indexes (PMIs) appear to be indicating slowing profitability, with the US PMI New Orders report recently moving below 50, an early indication of shrinking order activity.
Exhibit 1: US Institute for Supply Management (ISM) New Orders vs. Fed Funds Rate
August 1973–November 2022
Source: Capital Markets Insight Group. Indexes are unmanaged and one cannot directly invest in them. They do not include fees, expenses or sales charges. Past performance is not an indicator or a guarantee of future results.
We believe it’s likely that corporate profitability will slow and potentially contract as economic conditions weaken. Until recently, S&P 500 consensus earnings estimates for 2023 implied high single-digit growth, which is difficult to reconcile with increasing signs of slowing economic activity.1 We believe we are early in the process of management teams and market participants revising down earnings expectations for 2023 to reflect the more challenging economic conditions. The effect of lower earnings could put further pressure on broader equity market valuations over the coming year.
Exhibit 2: Institute for Supply Management (ISM) New Orders vs. S&P Earnings Per Share (EPS)
February 1991–November 2022
Source: Capital Markets Insight Group. Indexes are unmanaged and one cannot directly invest in them. They do not include fees, expenses or sales charges. Past performance is not an indicator or a guarantee of future results.
With these statistics and others in mind, we think the probability of a recession over the coming 12 months has increased, but is not certain. Worsening developments in the Russia-Ukraine war, rolling COVID-19 shutdowns in China, or any other number of potential vulnerabilities would add further pressures.
Despite our cautious outlook over the coming year, we would expect to see periods of market rallies, as investors look to anticipate an earnings trough and improving economic prospects. Bear-market rallies are a common feature of extended market declines, but ultimately, as inflation recedes and investors begin to look through slowing growth to identify new opportunities, we believe the stage will be set for an attractive period for equities.
The ballast of dividends
In an environment of continued market uncertainty, we believe investing in high-quality companies with strong business models and growing dividends can reduce volatility and help weather the potential market storm. Even if share prices stagnate, high-quality companies which continue to grow their dividends will see rising dividend yields, bolstering total return prospects. The long-term expectation then is that share prices should ultimately catch up to dividend growth, but either way, the investor would be paid. This is a tried-and-true strategy which has historically provided resilient downside protection while also providing exposure to upmarket expansion opportunities. The rationale is intuitive: those companies which can commit to paying a dividend through the ups and downs of a market cycle tend to be profitable, stable companies. The dividend growth track record acts as a confirmation of a company’s quality and overall resilience.
Exhibit 3: Stocks by Dividend Policy
Risk vs. Return
10-Year Period Ending September 30, 2022
Source: © 2022 Ned Davis Research (NDR) Group, Inc. As of September 30, 2022. The chart represents dividend growers and initiators and dividend and non-dividend-paying stocks (as defined by Ned Davis Research Group) of the S&P 500 Index Geometric Equal-Weighted Total Return Index, which is calculated using monthly equal-weighted geometric averages of the total returns of all dividend-paying stocks and non-dividend-paying stocks. NDR classifies a stock as a dividend-paying stock if the company indicates that it is going to be paying a divided within the year. Dividend growers and initiators include stocks that increased their dividend anytime in the last 12 months. Non-payers are if the stock’s indicated dividend is zero. Indexes are unmanaged and one cannot directly invest in them. They do not include fees, expenses or sales charges. Past performance is not an indicator or a guarantee of future results.
We believe that these features provide an “all-weather” approach to equity investing. Ideally, these companies demonstrate effective capital management, balancing investing in attractive secular growth opportunities which can generate strong returns through a market expansion, while providing the stability of consistent dividend growth in difficult market environments. These companies typically enjoy a quality bias, demonstrate inherent resilience by their commitment to growing their dividends and comprise a diverse range of sector and geographic exposure, as well as investment styles, allowing for the creation of a balanced portfolio of long-term investments. This investment approach has historically helped create a less volatile return stream benefiting from the long-term compounding of returns, while providing relatively attractive performance in down markets.
While none of us can say how this episode of market weakness ultimately will play out, we believe an allocation to core equity exposure through companies with growing dividends could form the bedrock of an investor’s equity portfolio, regardless of the market cycle.
Endnotes
- There is no assurance that any estimate, forecast or projection will be realized.
WHAT ARE THE RISKS?
All investments involve risks, including possible loss of principal. The value of investments can go down as well as up, and investors may not get back the full amount invested. Stock prices fluctuate, sometimes rapidly and dramatically, due to factors affecting individual companies, particular industries or sectors or general market conditions. Value securities may not increase in price as anticipated or may decline further in value. For stocks paying dividends, dividends are not guaranteed, and can increase, decrease or be totally eliminated without notice. While smaller and midsize companies may offer substantial opportunities for capital growth, they also involve heightened risks and should be considered speculative. Historically, smaller- and midsize-company securities have been more volatile in price than larger company securities, especially over the short term.
Actively managed strategies could experience losses if the investment manager’s judgment about markets, interest rates or the attractiveness, relative values, liquidity or potential appreciation of particular investments made for a portfolio, proves to be incorrect. There can be no guarantee that an investment manager’s investment techniques or decisions will produce the desired results.
