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17.01.2023
ERP at cycle lows – earnings risk has to be seen to be believed
Growth expectations trump financial conditions concern

Risky assets have rallied globally as expectations on growth have risen relative to expectations on tighter financial conditions – Goldilocks has made a return.

In the US, inflation is falling and while economic data is moderating we have the lowest unemployment rate of this cycle with average hourly earnings well off the peak.

Europe has benefited from falling gas prices. While China re-opening is also supporting global growth expectations.

US equity risk premium back to 2005-06 period when VIX averaged mid-teens.

From their October lows, MSCI China has risen 52% and DAX 26%. In the US, small caps +15% and the S&P500 is back at its 200d MA. VIX has breached 20% and now below its 2022 lows.

The equity risk premium has continued to decline to new cycle lows and where we were during in 2005-06 when VIX averaged in mid-teens territory. Evidently, the market has been quick to make the assertion monetary policy indigestion is unlikely.
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The market expects earnings expectations to trough this summer?

This leaves us with pondering the lagged effect of inflation and tighter financial conditions on corporate earnings. The rule of thumb is that stocks trough 6-9mths before earnings do.

If the market trough was October-22, the expectation is that earnings expectations will trough this summer.

12mth fwd EPS has seen so far a gradual 4% decline from its peak last summer.

This earnings season, companies have to guide this quarter for the year and historically the incentive has been to set the bar low enough so they can beat - the usual earnings playbook game.

Earnings season has only just commenced with the banks – corporate commentary will heat up over the next two weeks.

S&P500 LT model confidence has been falling (50%) reflecting this debate between hard / soft landing

On our LT model the S&P500 was cheap to model in mid-December but now back at model value.

On the LT model, the focus on economic growth peaked in December and has since drifted lower.

Financial conditions through USDCNH, credit spreads and Fed rate expectations are still dominant drivers for the Goldilocks view.
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Tentative signs pockets of the equity market are moving somewhat ahead of macro-warranted valuations

Qi’s ST models have been exhibiting higher model confidence during this potential regime shift, with over-extensions more notable in consumer-centric sectors:
  • S&P500: ST model confidence is high at 86% - the index is at +0.8 sigma (+2.6% rich)
  • IWM: ST model confidence 67% at +1.5 sigma but also LT model confidence 73% and +0.6 sigma
  • XHB: ST model confidence 76%, +1.1 sigma (KB Homes warned recently of higher cancellation rates in orders)
  • XRT: ST model confidence 73%, +1.3 sigma
  • KBE: ST model confidence 58%, +1.4 sigma
  • HYG: ST model confidence 82%, +1.1 sigma
  • Copper: LT model confidence +83%, +0.8 sigma
  • DAX at model value on ST and LT models
  • Companies with high sales exposure to China – majority of names trade to rich to macro-warranted values
If earnings weakness had been the main fear in consensus outlooks, the next few weeks will be telling as we enter what has been a big area on the S&P500 of 4000-4100.

The question we are left with is whether the risk-reward here is attractive enough to bet on a soft landing. Investors will only benefit from for lower European gas prices or China re-opening for so long.
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