With silver’s momentum stalling, could the S&P 500 help the bears feast?
While stagflation or a recession could have bullish implications for silver, a sharp drawdown of the S&P 500 could upend that optimism. For example, the white metal sunk to its 2022 lows alongside the S&P 500 in September and October, and liquidations often affect all risk assets. So, if the S&P 500 suffers mightily as the Fed suppresses demand, the silver price may not look so nice when it’s all said and done.
Morgan Stanley’s Chief U.S. Equity Strategist Mike Wilson wrote on Jan. 9:
“Our concern is that most are assuming 'everyone is bearish,' and, therefore, the price downside in a recession is also likely to be mild (SPX 3,500-3,600). On this score, the surprise might be how much lower stocks could trade (3,000) if a recession arrives.”
He added:
“When a recession arrives, the [equity risk premium] always rises significantly from whatever level you are starting at. In other words, if you think a mild recession is coming, you cannot assume the market has priced it given the ERP is at its lowest level since the run up to the Great Financial Crisis in 2008.”
Please see below:
To explain, the ERP measures the expected return over the risk-free rate that investors require to own stocks. When economic conditions are prosperous, the ERP declines because risks to corporate earnings fall. However, when recessions arrive, the dynamic reverses; and while nine of the last 10 bouts of rising inflation have ended with recessions, the prospect is far from priced in.
For example, the blue line on the right side of the chart shows how the ERP is near its pre-GFC lows, despite ~40-year high inflation and a hawkish Fed. More importantly, the vertical pink bars highlight how when recessions arrive, the ERP often rallies by 400 to 700 basis points; and with higher risk premiums culminating with lower stock prices, another bout of panic could reprise what occurred in September and October.
Wilson concluded:
Lower inflation “ignores the ramifications of falling prices on profit margins, which is likely to outweigh any benefit from the perceived Fed dovishness equity investors are dreaming about later this year....
“The bottom line, we don't think a 3,500-3,600 S&P 500 is consistent with the consensus view for a mild recession. That is one way the consensus could be right directionally, but wrong in terms of magnitude.”
So, while the S&P 500 may be in the midst of a short-term uptrend, the medium-term implications are much more ominous.
Speaking of which, the consensus expects an unrealistic outcome where inflation recedes rapidly and corporate profits remain uplifted. As such, they expect ~$229 in S&P 500 earnings in 2023 (as of Jan. 9), which amounts to 4.3% year-over-year (YoY) growth.
Please see below:
Source: Yardeni Research
Conversely, Wilson’s base case is $195, and his bear case is $180. Likewise, UBS’ strategists told clients on Jan. 5:
“With UBS econ forecasting a U.S. recession for Q2-Q4 '23, the setup is essentially a race between easing inflation and financial conditions versus the coming hit to growth and earnings.
"We forecast S&P 500 2023 EPS to fall >11% to $198 with margins declining below '20 levels for S&P ex Fins/Energy. We see 3,200 in Q2 on 14.5x fwd EPS of $220 as a reasonable trough assuming further cuts to estimates in line with a pre-recession pace.”
As a result, if sub-$200 EPS occurs alongside a recession in 2023, a sharp spike in the ERP could dramatically impact silver’s performance.
Overall, risk assets remain in la-la land, as investors’ expectations contrast fundamental reality. In 2021, corporate revenues and profits were uplifted by inflation, as nominal metrics benefited from price increases, even alongside flat volume. But, many companies had little real (inflation-adjusted) growth, and those price increases were paramount to meeting expectations.
Therefore, if those price increases go away and inflation recedes, nominal revenue and earnings should decline along with them. Consequently, the crowd should confront plenty of ‘surprises’ throughout 2023.
How do you see the fundamentals unfolding? Why is positioning so optimistic despite the economic risks? Can inflation decline without crimping the S&P 500’s EPS?
Alex Demolitor
Precious Metals Strategist