Our primary concern with regard to the S&P 500’s earnings outlook for 2023 is that banks are indicating a buttoning up of their lending standards, an occurrence that sometimes indicates corporate profit trouble. The fourth quarter marked the fifth in a row in which banks’ total loan books witnessed a tightening in the Fed’s Senior Loan Officers Survey, to a net 31.3%. That reading matches levels seen in 2001, 2007 and 2020, each of which witnessed a fall in S&P 500 earnings thereafter (figure 12).

Should a broad market earnings decline come to pass in 2023, that would pose a sharp contrast to the current Street consensus estimate, which sees Index-level operating earnings growing from $201.45 in 2022 to $228.61 next year, a 13.5% boost.2

Another issue the market will need to confront is the speed with which the wind has come out of housing’s sails. The National Association of Home Builders (NAHB) Market Index peaked in November 20203, collapsing thereafter.

Because housing tends to lead consumer confidence, we anticipate risk to public sentiment in 2023. This, too, poses downside potential for the S&P 500’s earnings prospects (figure 14).

Over the last decade, it was nearly impossible not to make money in U.S. stocks. Across cap spectrums, S&P 500, 400 and 600 components reporting negative earnings managed to return 8%–13% as a collective, depending on their market cap grouping (figure 15).

But notice what happened in asset classes that did not have a great bull market. The MSCI Emerging Markets Index returned 0.79% over the last decade; inside it, companies that were unable to turn a profit posted annualized losses of 5.76%.

If S&P 500 earnings disappoint in 2023, as we anticipate, we are hard-pressed to see expensive stocks and those with negative earnings presenting themselves as a haven.

As these negative earners encounter what we believe to be a choppier market than the one witnessed from 2009–2021, the market will need to confront a potential rotation to small-cap leadership in the 2020s. Over the 15 years to the end of the bull market, the top decile of stocks by market capitalization outperformed the bottom decile by five percentage points per year, a feat only surpassed by the 1984–1999 window that ended with the dot-com blowup. We expect figure 16 to mean revert, but it’s important to avoid land mines inside small caps. An Index such as the Russell 2000 has 26% of its market capitalization in companies with negative earnings, a far greater proportion than the S&P 500 or the Russell 1000. The small-cap rotation, should it come to pass, may leave many unprofitable firms behind.

As for emerging markets, we continue to believe China is investable, though the further concentration of political power breeds risk in equities. However, there’s significant inefficiency in the market’s pricing of China risk; overreactions to both good and bad news are common.

We continue to assess very low risk of US-China conflict over Taiwan. At this juncture, due to the unknown path of the reopening process and the fact that China’s political calendar starts around March, it is premature to put too much conviction behind the Street’s tepid economic forecasts.

We keep coming back to the dollar’s bull market, which got itself to the point where its real effective exchange rate (REER) reached highs last seen at the turn of the century. Should the dollar come off the boil, it may be the setup needed for MSCI Emerging Markets Value to get the upper hand on MSCI USA Growth (figure 17).

This concept also applies to non-U.S. developed market stocks, though we are still cautious on the group, owing to our trepidation with regard to the duration and severity of the Russian invasion of Ukraine. Nevertheless, we have eyes on two major DM components—Britain and Japan—both of which are showing valuation appeal and potentially some newfound competitiveness owing to the collapse in the British Pound Sterling (GBP) and Japanese Yen (JPY).