The S&P 500 is having one of its worst starts to the year ever, and while a number of big name investors say we there's plenty more room to fall, economists at Goldman Sachs Group Inc. are arguing that the equities rout doesn't necessarily signal a coming recession in the U.S..
Their argument strikes at the heart of the recent debate over whether a slump in corporate earnings—the so-called "earnings recession"—will develop into a full-blown U.S. economic retreat. The Goldman team led by Elad Pashtan posit that even after $1.6 trillion has been wiped off the market value of the S&P 500 index in the first dozen trading days of the year alone, there's no reason to panic about the wider economy, at least not yet.
"Although equity selloffs do coincide with most recessions, large selloffs do not necessarily presage recessions," they note, citing four key reasons that stocks may move differently to U.S. growth.1. Industry composition in the S&P 500 vs. the U.S. economy
Pashtan and Co. argue that the difference between sector weightings needed for economic growth and the S&P 500's composition is important. "For starters, the U.S. economy includes government expenditures, which account for 17.7 percent of GDP but are only indirectly accounted for in the equity market (via purchases from public firms)," they say. Below is a table from the note showing the differences. The component that is making the most impact right now is the energy sector. Correlations between oil prices and the S&P 500 are the highest they've been in years, and that has been a huge drag on stocks both in and out of the energy sector. 2. Different inflation measures
Goldman notes that while companies report earnings in nominal dollars, meaning they aren't adjusted for inflation, economists focus on GDP tracked in real (adjusted) terms. "As inflation declines, firms’ nominal levels of sales, earnings, and dividends may also correspondingly fall (although lower input costs may provide some offsetting effects)," the Goldman team says. Furthermore, as longer-term inflation expectations continue to fall, market-implied dividend payouts of S&P 500 stocks have also tumbled, "serving as a headwind to equity valuations but not necessarily to real economic output."3. Labor costs and profit margins
Thirdly, there are continued albeit early signs of wage growth. This is usually seen as a good thing for the broader economy but might not be so great for corporate profit margins. "Data from the national income and product accounts (NIPA) show that wage income is now accounting for a growing share of output, and corporate profits account for a correspondingly declining share," the note says. "Lower corporate profitability is a clear headwind to equity valuations. But GDP is a measure of total expenditure, which is equal to the economy’s total income, not just corporate profits." The below shows correlation between labor costs and corporate profit margins. 4. Where the corporate sales are coming from
Last but certainly not least, many have been keeping a closer eye on the origins of U.S. corporate revenues given the strengthening greenback and a slowdown in the Chinese economy. Goldman points out that while one third of sales for the median firm in the S&P 500 are international, total exports only account for 12.5 percent of GDP. "Accordingly, the S&P 500 is more likely to face growth headwinds from an appreciating dollar and/or a growth slowdown abroad than the U.S. economy would as a whole," they write. In fact, the team points out that during the recent selloff, firms that get more of their sales from overseas have done far worse than those that focus on the domestic U.S. market.
In classic Wall Street style, however, the Goldman economists hedge their bets, citing the potential for an even starker sell-off to weigh on the business cycle: "These four differences may imply that the current weakness in the equity market overstates the headwinds facing the real economy—although any further equity market weakness incrementally increases the odds that economic growth may be slowing."
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