A key question for us is earnings growth, in the context of an economic growth wind back or contraction, and the extent it is being incorporated into the current equity market’s assessment. Either it has been incorporated and therefore the market is satisfied to move on, or it hasn’t and the market is underestimating the risk. Given the uniqueness of this cycle, we think the latter.

It’s fair to say that the US went sideways over the last two quarters, albeit slightly negative. The Federal Reserve would normally be concerned, but this rate cycle is squarely about inflation control and economic growth is the necessary casualty. We have noted this previously.

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Where the RBA and Federal Reserve sought wages growth as part of their extraordinary monetary policy actions through and beyond COVID, they now must engineer a reduction in economic activity to moderate wages growth.

It is difficult not to see earnings weakness in the face of substantial financial condition tightening; both monetary tightening and household expenditure tightening. When our economies are driven by over 60% consumption demand, this affects growth and earnings. At this stage, equity markets in their keenness and hope that the Federal Reserve will moderate their severe tightening bias, are seemingly completely overlooking any recession-based earnings falls.

In the US, we see the potential/need for the Fed Funds rate to go to around 4% (from the current 2.25% to 2.50%). Whilst this wouldn’t significantly impact services sector demand, the same could not for said of the goods sector – construction, housing, autos and the sectors that hang off these. The clear imperative of the Federal Reserve to return to the stated inflation objective would mean the goods economy is likely to face a meaningful growth contraction and perhaps recession, and this will see earnings come under pressure which markets are yet to account for.

The graph below shows that the US equity market has just seen some very small S&P500 earnings revisions. Where equity markets are assuming the Fed will not continue to severely hike into declining growth, in this instance the danger is in the assumption – to arrive at their required inflation destination, they will accept the collateral damage of recession and continue to raise rates contrary to equity market expectations. Earnings will be the other collateral damage. Continued volatility in equity markets should therefore be anticipated over the next six months. Equity markets do look forward, but just be mindful that they haven’t completely overlooked a whole segment of the economic cycle.