investment insights
The US equity market: signals and scenarios for 2024
Key takeaways
- A mix of forces have led the S&P 500 in 2023; from strong US spending, a recession that has so far failed to materialise, muted contraction in corporate earnings and high expectations around AI. We discuss three scenarios for 2024
- Our base case is for continued US disinflation and sub-trend economic expansion with stable corporate margins and positive earnings growth. We retain a broadly neutral equity allocation in this environment
- While recession risks have reduced, they have not disappeared. If the US were to slow sharply into 2024 as high interest rates reach all sectors of the economy, we may see a low double-digit decline in the index
- A bull scenario, thanks to a potential re-acceleration in manufacturing activity, without further aggressive rate hikes, may see corporate earnings jump, taking the S&P 500 higher.
This has been a complex year for equity markets, driven by a resilient US economy in the face of high interest rates, and performance dominated by a limited number of large capitalisation technology stocks. What are the key trends and lessons of the year to date? As the third-quarter earnings season begins, we look at three possible scenarios for equities, focussing on the US market, through the end of 2024.
The S&P 500 stands at around 4,330 points today, a 13% gain compared with the start of 2023. That is a remarkable performance given investors’ expectations for a US recession earlier in the year. Furthermore, earnings have been lacklustre and interest rates have moved higher. What then explains this performance? The S&P 500’s rise was driven in part by changes in investors’ expectations for valuations and was highly concentrated in a handful of mega-cap stocks. The technology, communication and consumer discretionary sectors have all outperformed the wider index as seven stocks, specifically Apple, Alphabet (Google), Amazon, Meta Platforms (Facebook), Microsoft, Nvidia and Tesla, drove returns, especially over the first six months of 2023, in part thanks to the promise of artificial intelligence’s transformative impact. So, the market performed, yet most stocks did not (see chart 1).
In response, some commentators have drawn parallels with historic periods of concentration in which stocks jumped and then crashed, concluding that 2023’s gains are necessarily negative for markets in the near future. We have a more nuanced view. The corporate fundamentals and valuations of the few stocks that have dominated performance are more robust now than phases such as the ‘nifty fifty’ of the 1960s/70s or the crash in technology, media and telecom stocks in 2000. Market cap concentration on its own, we believe, is not a signal that the market has peaked.
Three scenarios for 2024
As we approach the end of this year, we take stock of recent developments and start thinking about what might come next, with a view to the end of 2024.
We examine three plausible broad scenarios for the evolution of the S&P 500 index over the next 15 months. First, a most-likely scenario of continued disinflation and sub-trend growth. Second, a delayed US recession, perhaps triggered by the lagged effect of monetary tightening and/or a resurgence of inflation. Finally, we consider the possibility of a rebound in economic growt (see chart 2).
Base case; slowing growth, continued disinflation
Taking these in turn, our base case for corporate revenue growth reflects the macroeconomic expectations for current trends of slowing real GDP accompanied by continued disinflation. In this environment, we would expect corporate margins to remain broadly stable thanks to still-positive nominal economic growth. That in turn would allow firms to continue to post positive earnings growth of around 6%, compared with a consensus forecast of 12%. While any decline in economic growth inevitably puts pressure on corporate profits, such an environment should also offer some relief in the form of interest rate cuts by the Federal Reserve towards the end of 2024, and as such we expect the price-to-earnings ratios to stay around their current levels.
We see this as a typical late-economic-cycle environment for equities, and US valuations as elevated but no longer outright expensive. While not a metric that we believe offers much guidance over the short term, after the market declines of recent weeks, price-to-earnings ratios are close to their ten-year averages. From a sector perspective, we believe that the energy and consumer staples stand to benefit. We also increasingly like the technology sector, which if growth holds up, remains relatively attractive thanks to the influence of AI, Cloud storage, the Internet of Things and the deeply-ingrained digitalisation of our working and private lives.
Resurgent inflation and recession
One of the main consensus risks for 2023 was that of a deep recession. While that did not take place and the risk has reduced, it has not disappeared altogether. In the case of a sharper US slowdown into a recession in 2024, reflecting the cumulative impact of monetary tightening, we might expect to see a 20% decline in earnings growth, which would be typical of the first year of a recession. Earnings multiples should rise in such a scenario as the equity market looks beyond the decline in the index to a recovery, helped in part by the Fed cutting rates sooner and more aggressively, and so possibly taking the S&P 500 to trade around 3,800 by the end of next year. That would represent a low double-digit decline for the index, and favour more defensive stock sectors and other bond proxies, such as healthcare. Regionally the US, Switzerland, and even the UK, would likely do well in relative terms due to their defensive properties sought by investors.
Booming growth, bull scenario
What about a faster recovery, rather than a slowdown? In September the ISM purchasing manufacturers index (PMI), a measure of business confidence, contracted at its slowest pace in ten months. In addition, a number of forward-looking indicators suggest that a further recovery is plausible.
A re-acceleration in growth led by the manufacturing sector is a factor for a bull case scenario, especially if inflation were to rise again, and with a long lag, as it typically does. The Fed may not have finished its hiking cycle in such a scenario, but is unlikely to raise rates aggressively either. If there were a broad acceleration in economic activity, accompanied by corporate pricing power, an above-consensus jump in earnings for the S&P 500 is not inconceivable. Still, multiples would contract a little, reflecting higher costs of capital. That could take the index to trade above 5,000 points 15 months from today. At the regional level, US and Japanese equities could outperform relative to other markets. From a sector perspective, this environment would not favour highly-leveraged, slower growing businesses exposed to the high cost of repaying debt and would argue against investments in telecommunications, utilities, or real estate, for example.
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