Disclosure – Non-Independent Marketing Communication
This is a non-independent marketing communication commissioned by JPMorgan American. The report has not been prepared in accordance with legal requirements designed to promote the independence of investment research and is not subject to any prohibition on the dealing ahead of the dissemination of investment research.
The damage so far
A useful way to illustrate how severe the fall in US equities has been is by looking at the forward price-to-earnings (P/E) ratio of the S&P 500 Index. The forward P/E ratio measures the price of the index divided by estimated earnings-per-share of its constituents for the next 12 months. This multiple provides a meaningful comparison against historical market movements and is a useful way to break down the different drivers of return: price and earnings.
Exhibit 1 shows the decline in the P/E ratio since the start of the year. Since its peak at 21.4x in early 2022, the S&P 500’s P/E ratio has declined 19% and now sits just above its 25-year average.
Exhibit 1: Equity volatility has been driven by a re-rating in valuations - S&P 500 price return decomposition
Source: Compustat, FactSet, Standard & Poor’s, J.P. Morgan Asset Management. Earnings estimates are based on estimates from Standard & Poor’s and FactSet Market Aggregates. Earnings and multiple growth are both year-to-date percent changes of next twelve-month estimates. Past performance is not indicative of future returns. Data as of 31 July 2022.
A tough outlook
With the US Federal Reserve set to continue raising interest rates over the coming months, equity market volatility will likely persist and P/E valuations will likely remain under pressure. This means company earnings are likely to be the main driver of returns for investors. Although earnings for the second quarter of 2022 were better than expected, the outlook for profits rests on the ability of companies to defend profit margins.
Rising inflation has strained profit margins. To be able to defend these margins, JAM’s co-managers Timothy Parton and Jonathan Simon believe there are three levers that companies can pull – reduce costs, pass costs along in the form of higher prices, or focus on automation and efficiency. In the current environment, businesses seem inclined to pull all three. There have been hiring freezes and layoffs in sectors such as technology, while costs are likely to be passed on in the industrial, energy, materials and consumer staples sectors.
Across the board the managers expect a greater focus on productivity improvements, which could potentially be supported by some further investment into efficiency by companies. Exhibit 2 shows how margins have started to decline from their 2021 highs, but Parton and Simon don’t expect a collapse similar to previous recessions. Instead, they forecast margins to stabilise in the mid-12% range barring a more significant downturn in the economy.
Exhibit 2: Margins will decline from all-time highs, but seem unlikely to collapse - S&P 500 operating profit margin
Source: Compustat, FactSet, Standard & Poor’s, J.P. Morgan Asset Management. Past performance is not indicative of future returns. *S&P 500 2Q22 profit margins estimated is based on current operating earnings and sales per share estimates from Standard & Poor’s. Data as of 31 July 2022.
Hunting for opportunities
The sell-off in US equities has created opportunities to invest in select areas of the market at attractive prices, the managers say. Value-style companies – which tend to trade at lower P/E ratios during normal markets – are looking even cheaper and, given how far prices have fallen, valuations should be less sensitive to any further rate increases. Growth companies – which are categorised by their relatively high P/E ratios and strong expected earnings growth – are now trading at more attractive levels and investors are likely to increase exposure to those growth companies which are currently profitable.
Overall, the JAM portfolio is tilted towards companies with large market capitalisations in sectors and industries that are able to continue growing profits against a backdrop of slowing economic growth, elevated inflation and rising interest rates.
A prime example of this is technology bellwether Microsoft1. Although most well known for its computer software business, the company interacts with almost everyone in the world through its brands, which includes the likes of Xbox and LinkedIn. The managers believe that the reliance on Microsoft products globally has created an economic moat for the company, enabling it to protect its significant margins. This, combined with an experienced management team, means Microsoft has the defensive qualities to weather a tougher economic backdrop.
Despite its size – Microsoft is the third biggest public company in the world2 with a market capitalisation of almost USD2tn – Parton and Simon believe that it still has a compelling growth story. They highlight Microsoft’s cloud and digital advertising businesses as underappreciated by the market, particularly as the latter division has grown faster than its counterparts at Amazon and Google more recently.
1 The companies above are shown for illustrative purposes only. Their inclusion should not be interpreted as a recommendation to buy or sell.
2 J.P. Morgan Asset Management August 2022