A Hemingway moment for markets?

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Articles by Jasmine

Jasmine Yeo

Fund Manager

10 March 2023

In Ernest Hemingway’s The Sun Also Rises, a group of young expats travel to Pamplona for the running of the bulls. One expat, Mike, is asked how he went bankrupt. His reply: “Gradually and then suddenly.”

As the sun now sets on 2023’s first earnings season, we at Ruffer fear equity markets are heading for a Hemingway moment. Why? Because the gradual decline in corporate earnings estimates could become a sudden earnings shock.

The green line on this month’s chart shows the real (inflation adjusted) earnings per share (EPS) of the S&P 500 over the last 150 years on a logarithmic scale, along with the historic growth trend in the post war era. Clearly, corporate earnings are extremely elevated – 61% above the post 1945 line and 96% above the post 1871 trend. The most recent peak in real EPS (in the fourth quarter of 2021) even exceeded the peak of the 2000 bubble. Whichever way you cut it, earnings are high.

US companies have been enjoying such plump margins thanks to the disruption of the pandemic and the subsequent supply chain issues, as well as over a decade of zero interest rates. As a result, pricing power has been high and borrowing costs low.

But both these tailwinds are reversing, meaning US corporate profits will remain under downward pressure in 2023. This pressure could be exacerbated by macro factors such as higher energy costs, supply chain re-shoring, wages, labour hoarding and the energy transition. An earnings bear market where EPS just return to trend – never mind overshoot – would be brutal, with severe implications for equity markets.

Crucially, investors are not being rewarded for taking on this uncertainty. Equity risk premiums are at a 15 year low. For example, a six month US T-bill offers roughly the same yield as the earnings yield, but without any earnings or duration risk. Whilst this is a measure of income and thus does not account for capital growth, it is a startling proposition nonetheless.

For the coming months, we see a tactical runway for equity markets thanks to a confluence of supportive factors, including China’s re-opening, Europe’s energy-driven rebound, US consumer resilience and underlying liquidity driven by central banks in China, Japan and Europe.

However, we expect both fundamental factors and liquidity conditions to be challenged in the second half of the year, particularly as consumers draw down their covid savings buffers. And we are already seeing evidence a global rebound is inconsistent with sustained disinflation. Hence, we have used this year’s risk rally to dial up the protection in the Ruffer portfolio. We remain defensively positioned in the expectation that this year’s running of the bulls will end suddenly – and the unwary risk being gored.

#inflation, #liquidity

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A Hemingway moment for markets?