Disclaimer: The information and materials prepared are for internal use only and on how the Dancap Family Investment Office (“Dancap”) views current market dynamics. Dancap does not guarantee the accuracy or completeness of the material and it is not intended in any manner to be investment, financial, legal, accounting, tax or other advice and should not be relied upon.
Dancap's Current Public Equities Strategies
Dancap has a significant track record investing in public equity strategies through third-party managers. Our strategies tend to be actively managed, tax-optimized, and in the form of a managed account with daily liquidity and full transparency. This market overview focuses on Dancap’s current public equity strategies based on geographic region and looks to provide an update on current market dynamics, outlook, and risks.
The majority of Dancap’s public equites strategies are allocated to managers focused on US large cap stocks. Since our strategies are held in managed accounts, we are able to monitor our holdings on a daily basis and compare their daily performance to an appropriate benchmark. A smaller portion of our public equity holdings are allocated to third-party managers focused on non-US large cap companies with significant long-term growth potential. In any case, we look to invest with managers who can consistently generate alpha and outperform their respective benchmark, net of fees. On an absolute basis, we target minimum net annual returns of 10% for each of our strategies.
The S&P finished the year 2022 down 19%, marking its worst calendar-year return since the Global Financial Crisis in 2008. The decline was driven by the Federal Reserve raising interest rates aggressively in response to high inflation levels, with CPI inflation at 5.0% as of March 2023 and significantly above the Fed’s 2% target. Investors now expect the Fed Funds terminal rate to reach 5.0%, up from the prior forecast of 3.5% a year ago. Despite the Federal Reserve’s aggressive rate hike path, the US labor market remains robust and will make it more difficult for the Fed to achieve its 2% inflation target. As of March 2023, the unemployment rate was near its 40 year low of 3.5% and wage growth was 4.2% (nominal) on an annualized basis. The number of unfilled jobs is still almost 10m while the number of people unemployed people is only 6m.
To further complicate the outlook for interest rates, the recent turmoil in the regional banking sector has lead to a tightening of credit conditions, making it harder for businesses and individuals to access credit. This will almost certainly eventually lead to reduced investment and spending in the economy, which would have a negative impact on economic growth. Moreover, bank failures can lead to a loss of confidence in the financial system, which could further dampen economic activity. All of this has added uncertainty around the Fed’s future interest rate path, with markets now pricing a year end 2023 Fed Funds rate of 4.5%, down from their peak of 5.25%.
Since US inflation peaked at 9.1% in June 2022, S&P 500 forward P/E multiples expanded from their recent lows of 15x and are now trading at 18x, in line with their 10 year average. With US 10Y treasuries yielding roughly 3.5%, the equity risk premium (or ERP) is near its all time low at 200bps, well below its post-2008 average of 425bps. Strategists at Morgan Stanley believe that the ERP needs to move higher to reflect slowing economic growth and lower earnings per share expectations, and that a fair P/E multiple is closer to 15x.
Source: Morgan Stanley – 2023 US Equities Outlook: The Road Not Taken, November 22, 2022
According to the latest estimates from Factset (source), analysts are still predicting a decline in S&P 500 earnings for the first half of 2023. However, the magnitude of the decline has been revised since the previous estimate, with earnings now expected to decrease in Q1 by 4.4% YoY, versus prior estimates of a decrease of 7.1%. For Q2, analysts are currently projecting a decline of 5% YoY. Margins are expected to remain under pressure due to inflation and higher input costs from producers. In Q1 2023, margins declined to 11% from 12% in Q4 2022. Overall earnings per share (EPS) in 2023 are expected to increase by 1% YoY to $221 per share.
The yield curve has remained inverted for several months, with the 3M/10Y inversion reaching its peak of 177 bps in May 2023. While an inverted yield curve is still considered a recession indicator, the probability of a recession in the next 12 months is 55%, according to Bloomberg economists. In the event of a recession, or “hard landing”, economists at Goldman Sachs believe the S&P could fall to as low as 3,150 (18% decline from the start of 2023) based on a 14x P/E multiple and a decline in earnings by 11%.
Europe recently managed to avoid an energy crisis thanks to a milder-than-expected winter and sufficient energy inventories, leading to a decline of up to 85% in European natural gas prices from their peak in August 2022. This had a positive impact on European inflation, which peaked at 10.6% in October 2022 and did not reach the anticipated level of 15% some economists projected. As a result, some strategists, including those at Goldman Sachs who previously expected Europe to enter a mild recession in late 2022 or 2023 due to an energy crisis, are no longer predicting a recession in Europe for 2023.
Goldman Sachs suggests that the European economy is expected to be more resilient this time around compared to past recessions, as some sectors are likely to benefit from high inflation and interest rates. Specifically, the commodities and financial sectors could experience a boost, as inflation typically results in higher commodity prices and interest rates can lead to higher bank profits. Additionally, some sectors are also likely to benefit from China’s reopening, which is expected to increase demand for European exports. That said, there are still several risks to the European economy, and in the event the European economy falls into recession, earning per share (EPS) in the MSCI Europe Index could fall as much as 30%.