Even as stock markets have moved higher to begin 2023, the return outlook faces a daunting list of risks. Margins—the widening of which allowed earnings to soar for the past two years—are compressing, and the Fed may have to turn more hawkish as inflation is proving stickier than some expected. This battle is occurring with U.S. equity valuations at higher levels than at any time in the two decades before COVID.
- Equities have moved higher to start 2023, thanks to some promising data on inflation and growth.
- Risks to profit margins are significant, as operating leverage is turning negative.
- Corporate margins can (and have) declined in non-recessionary periods of slowing nominal GDP growth.
- U.S. equity valuations sit at levels equal to the highest seen in the two decades prior to the COVID pandemic, despite the highest interest rates in years.
- The combination of risks to margins, policy and valuations makes us inclined to seek opportunity outside the U.S., where valuations may be more reasonable and policy less draconian.