Recession may trump AI optimism

Share market bears are reluctant to cave in as the S&P 500 tests the upper end of its trading range, led by tech giants.

Traders discuss strategies on the floor of the York Stock Exchange on Tuesday. Picture: AFP

Sharemarket bears are reluctant to cave in as the S&P 500 tests the upper end of its trading range, led by a handful of mega-cap tech stocks that have surged on the AI theme.

AI and automation will undoubtedly be significant deflationary forces and powerful drivers of longer-term returns. But will they prop up the sharemarket if recession follows a period of stubbornly high inflation and aggressive rate rises, as many expect?

“While we believe AI is for real and will likely lead to some great efficiencies that help to fight inflation, it’s unlikely to prevent the deep earnings recession we forecast for this year,” says Morgan Stanley’s chief US equity strategist and chief investment officer, Michael Wilson.

This year was expected to be at best a neutral year for shares (China’s reopening was expected to offset recession risks in the US and Europe), but it has turned out quite differently so far.

The S&P 500 is up 9.2 per cent for the year to date, led by a 23 per cent rise in the Nasdaq Composite, although the cyclically heavy Australian market is up only 3.3 per cent.

Moreover, tech and consumer are the only S&P 500 sectors in the green this year.

Yet investors are more bullish than in early December, or at least far less bearish, given optimism around technology diffusion, specifically artificial intelligence, Mr Wilson says.

Valuations aren’t compelling and it’s not just the top 10-20 stocks that are expensive.

The S&P 500 median stock forward price-to-earnings multiple of 18.3 times is in the top 15 per cent of historical levels back to the mid-1990s, the S&P 500 ex-tech median PE of 18 times is also in the top 15 per cent of historical levels, and the equity risk premium is less than 2 per cent.

The S&P 500 median stock forward price-to-earnings multiple of 18.3 times is in the top 15 per cent of historical levels.

On the earnings front, Mr Wilson says a healthy re-acceleration to mid to high single-digit growth for both the S&P 500 and ex-tech is “baked into” consensus earnings estimates.

“This runs counter to our earnings model projecting 20 per cent downside to 2023 consensus,” he says. “From a macro standpoint, a number of risks continue to mount: a weakening and potentially L-shaped economic growth path, still elevated geopolitical uncertainty, a debt ceiling debate that has yet to be resolved, credit tightening in the regional banking system, and a Fed that could deliver on a ‘higher for longer’ rate path to make sure inflation gets under control.”

Indeed, the gains have been super-concentrated. Ten “mega-caps”, the market capitalisation of which now accounts for 31 per cent of the S&P 500, have driven nearly all the rise.

Canaccord Genuity chief market strategist Tony Dwyer says a US debt ceiling agreement could cause additional positive reaction from the sharemarket. But the S&P 500 is trading at 20 times his 2023 estimated earnings per share and offering an earnings yield of just 5.01 per cent, which is well below the six-month Treasury bill yield of 5.43 per cent.

US sharemarket volatility is unusually low, inflation remains stubbornly high and the risk of recession is arguably rising, even if the US is unlikely to default on its debt.

“Clearly, a solid debt-ceiling agreement could lift the market and sentiment, but the tactical ­issues, coupled with our macro ­issues suggesting recession, and elevated valuations may put risk assets in a ‘lose-lose’ economic framework,” Mr Dwyer says.

If Fed chairman Jerome Powell manages to pull off an elusive “soft landing” and employment remains high, services inflation is likely to remain elevated, keeping Fed policy tight. The US bond yield curve will stay inverted, and the outlook for credit will be poor – not a great environment for stocks.

If the economy does have a recession, earnings estimates will prove too optimistic, valuations for the broad market too high, and the sharemarket will fall, as it ­always does at the start of a ­recession.

“Clearly, the 27 per cent S&P 500 drop into the October low discounted an economic retrenchment, but we are now longer near those October lows,” Mr Dwyer says.

Macquarie Australian equity strategist Matthew Brooks says investors should be “bullet-proofing” their portfolios against the damaging effects of aggressive rate rises by owning “quality” stocks with stable earnings growth, strong cash flows and healthy balance sheets.

Quality companies are typically better equipped to weather the effects of rising interest rates than companies with weaker fundamentals, and may benefit from strong financial positions that allow them to invest in their business and take advantage of opportunities to expand their market share.

But BofA’s head of US equity and quantitative strategy, Savita Subramanian, and her team boosted their year-end target for the S&P 500 from 4000 to 4300 points earlier this week.

“The era of easy money is behind us, but that might be a good thing,” Ms Subramanian said.

“Over the past few decades we have enjoyed financially engineered growth: cheap financing, buybacks and cost cutting.

“Old economy cyclicals, capital-starved since 2008, have become disciplined and self-sufficient.”