DWS CIO Day: Higher Fed Funds rate, 4100 S&P target pushed to March 2024

The main theme of our CIO day was sticky inflation will force more hikes from central banks. This suggests a delayed but perhaps worse than slight recession. Our economists forecast 3.9% and 5.7% inflation for US and Europe in 2023. The U.S. Federal Reserve (Fed) Funds rate is expected to peak at near 5.5% in June. The European Central Bank (ECB) policy rate to peak at 4%. Both terminal rates likely come with long holds through 2023. We raised our 10yr Treasury yield 12-month forecast from 4.2% to 4.3%; which includes an expectation of a ~2.50% 10yr breakeven inflation rate and ~1.75% 10yr Treasury Inflation-Protected Securities (TIPS) yield. Long-term yields remain very uncertain for 2024, higher is possible, but if Fed hikes subdue inflation soon they could be well lower than our forecasts. DWS raises 12-month Euro target to $1.10 from $1.05 and keeps $100/bbl oil.

 

We pushed our 4100 S&P 500 target to March 2024, but slightly boosted most European equity index targets with the 3-month roll forward in time. We see high near-term 10% plus correction risk for the S&P 500 as it would be uncommon for it to find bottom while the Fed is hiking above neutral rates with S&P Earnings per share (EPS) stalled or declining and the current price-to-earnings (P/E) ratio still quite high. We estimate the fair value range for the S&P 500 for the rest of 2023 is 3700-4000.

 

Markets too quickly dismissed sticky inflation risk, taming inflation won’t be easy

Stocks rallied strongly in January into February as 2yr Treasury yields fell from their 5% autumn highs on a sanguine consensus view of steadily declining inflation that would allow the Fed to cut by 2023 end without a recession. We cautioned repetitively against such premature optimism. Since early February (until Silicon Valley Bank), all Treasury yields climbed as all macro reports year to date (YTD) and 4Q22 revisions show inflation still running too hot at the core; despite disinflation at goods, which is being driven by a goods demand/ manufacturing recession in progress.

 

A very tight labor market that is upset about purchasing power of pay, but also struggling to boost its productivity, suggests that unit labor costs could get stuck well above the Fed’s inflation target this year and next. Unfortunately, time is running out for the Fed to afford to be patient with inflation. Yields are creeping upward and the bond market is losing patience with high interest rate uncertainty/ volatility. This puts Fed in a tough spot of having to fight harder and take more hard landing risk. Also, Chair Powell’s Senate testimony last week reminded us that the longer it takes to tame inflation, the more politically difficult it will get.

Some risks might emerge very soon: Silicon Valley Bank fails on a deposit run

As 3-24 month Treasury bills and notes exceed 5%, it not only raises alternatives to equities but also for bank deposits, as most still yield lower and are unlikely to go quite that high. Thus, competition among banks for saver deposits will intensify. In this fight, smaller banks are disadvantaged. They offering less services and sometimes less safety is perceived and moreover they lack the excess of deposits and reserves as at the giant banks. The risks will obviously be greater for banks that mismanage their duration risk or have lower quality “flighty” deposit bases. Of course, some banks are more exposed to the more challenged parts of the economy like commercial real estate or less capital available for unprofitable early-stage enterprises. All considered, we think it important the Fed considers how to keep fighting inflation while helping to protect smaller regional and community banks. We’d be more reassured if the Fed didn’t hike the Discount rate upon further Fed Funds rate hikes.

 

S&P 4Q22 EPS fell a bit short of low expectations, 2023 EPS still drifting down

S&P 4Q EPS finished at $53.30 vs. $53.85 consensus earnings season start and our long standing $54 estimate. Some headline 4Q S&P EPS surprise figures are slightly positive, but only from analysts cutting 1-3 days before reporting for many companies. 2023 analyst consensus EPS still drifting down. It’s $224 now vs. $230 at year start and $251 last June. 1Q & 2Q 2023 consensus S&P EPS has been cut most to $50.94 and $54.57, -7.1% and -5.2% y/y. Consensus expects 2.5% y/y growth in 3Q and now 10% EPS y/y growth in 4Q, but this has significant downside risk. Profit margins in most developed markets still at risk.

 

S&P EPS quality deteriorating, quality metrics suggest unsustainable cash flow

Aside from stalled S&P EPS growth, another concern is deteriorating S&P earnings quality. The Generally Accepted Accounting Principles (GAAP) to non-GAAP EPS ratio averages 86% out of recessions, usually above 90% for healthy mid-cycle quarters. However, it fell toward 78% 2022 and 73% in 4Q, borderline levels only seen during recessions. Another metric we monitor is: (Net income + D&A) / (CFO – Stock Option Expense). Free Cash Flow vs. Net Income is more an indication of investment activity than earnings quality. But comparing Cash Flow from Operations (CFO) to Net Income + Depreciation & Amortization (D&A) over several years helps reveal reported earnings quality. This measure is at a two-decade high for non-GAAP based EPS or 15% higher than usual, and 10% higher than usual GAAP based, suggesting earnings overstate true profitability and steady-state free cash flow.