Amongst 30 analysts whose estimates and price targets on S&P 500 are tracked by Bloomberg, the one from Peter Berezin of BCA Research stands out. At 5,300, it is the lowest year-end target for the index and is 16 per cent below current levels. But make no mistake, Berezin is not a permabear and chooses his side based on the data that is coming in. For, when a US recession was the consensus forecast in 2023, he stood out for his optimistic call for the year, noting that there would be no recession that year and that an immaculate disinflation would play out. He was one of the few who got it right then. As US markets continue to surprise many with remarkable resilience, bl.portfolio caught up with Berezin to understand the current state of US markets and macros, and the rationale behind his cautious view.
How concerned are you about the possibility of a US recession this year? Is your Street low S&P 500 target based on a recession scenario playing out?
Yes. So the 5,300 target is a weighted average of price targets in two scenarios. The first scenario is one where the US does enter a recession this year. We assign a 60 per cent probability for that. In that case, EPS estimate for S&P 500 falls to $250 for this year. Estimates for this year are sort of drifting lower and in a weak economic growth scenario, 250 would be entirely plausible. And then I attach a multiple of 18 to that 250 and I get 4,500 as the price target in the event of a recession.
But then while recession is the base case in my view, it is definitely not a certainty. There’s still a chance we avoid a recession. If we avoid a recession, then I think the S&P 500 can go up to about 6,500 with EPS hitting around 265. So weighted average price target we get based on the 60-40 per cent split yields a target of 5,300.
My view is that a recession is more likely than not, later this year. If that happens, then the S&P 500 will probably fall to around 4,500.
The multiple you have assigned to S&P 500 in event of a recession is 18 times. That is still high by historical standards for a crisis scenario.
Yeah, it’s a valid point. And you could actually argue that 4,500 would be a fairly optimistic outcome in recession, given that in a mild recession, PE multiples typically fall into the teens and in a deep recession it is not at all uncommon for PE multiple to fall into single-digits.
So yes, 18 times is not particularly bearish, but the reason I have this PE multiple is – one, I don’t think this recession will be especially deep. This is because there aren’t major imbalances in the economy – at least in the private sector there is not a great deal of leverage, bank balance-sheets are in good shape, there isn’t as much of over-supply in housing as it was in 2007, etc. So this suggests a mild recession with a modest impact on earnings.
Two, the other reason a higher multiple may be justified is the fact that we are in the midst of AI boom. It hasn’t hit productivity growth yet and I suspect that we are going to see better productivity data over the coming years and if that were to happen, that would certainly justify a higher PE multiple for the equity market.
Is there any risk scenario where you think there might be stronger compression in PE multiples, any tail risk that you think can cause that?
The big tail risk is in the White House. It’s certainly possible to envision a scenario in which, for example, the EU fails to strike a deal with Trump and this can impact markets.
Trump imposes 30 per cent tariffs on the EU. The EU then feels that politically they have to retaliate, even if it might not be in their economic self-interest to do so.
Trump then turns around and further raises tariffs. And before you know it, you get a breakdown in trade, across the Atlantic. Now I think Trump would sort of back down at some point. But the problem is that the economic damage from these sorts of disruptions, don’t appear in the data immediately, but they could certainly impact the economy later. It tends to reduce confidence, leads to less spending. This can kind of feed on itself and cause a larger recession than you would otherwise have. So I think that’s one consideration that this trade war really does spiral out of control.
The other thing that I’m worried about is the bond markets. The US has got a budget deficit of almost 7 per cent of GDP with unemployment rates at a historically-low level of 4.1 per cent. It’s unprecedented to have such a large budget deficit in a full employment economy. If we enter a mild recession, then spending on social programmes will increase just automatically because more people will qualify. But tax receipts will decelerate and that budget deficit could very easily go to 8-9, maybe even 10 per cent. And then the question is like, what does the bond market do in a normal recession?
Under normal circumstances, bond yields fall during recessions. That provides a buffer for the economy. But if we have a budget deficit that’s approaching 10 per cent of GDP and there’s no real hope for that deficit to go down meaningfully over the coming years, then maybe bond yields don’t fall and in which case the impact on the economy would be worse than in a typical recession. So I do worry about both the fiscal side and the trade side — the two can actually work together to cause all sorts of problems.
Even if the Fed cuts rates, it’s very possible for term premium to rise in a way that negates any of the benefits from lower short-term rates. I wouldn’t say that this outcome is highly likely, but the risk is certainly there.
In your recent report, you have mentioned that there is a 30 per cent chance of a major fiscal crisis this year….
I don’t know if a recession is necessary for that dynamic to occur. It could occur even outside of recession and then cause a recession. So, it could be the consequence of recession, or it could also be the cause of the recession.
Budget deficits of the magnitude that the US currently has is not sustainable. The US needs a budget deficit of around 3.5 per cent of GDP to stabilise the ratio of debt to GDP. We’re double that number at around 7 per cent now, so something has to change.
Currently, the equity markets are taking comfort from higher government spending. When do you think they’re going to start factoring the risk that is posed by the bond market and this unsustainable fiscal deficit?
That’s impossible to know. It’s a bit like looking at a mountain and seeing all of that snow on the side of the mountain and saying, ‘OK, you know, when is the avalanche gonna start?’
Well, we don’t know which snowflake will cause that avalanche. All we know is that if it keeps snowing, eventually there will be an avalanche. So we’re in that very fragile situation where something could break. But there’s just no way to say whether it’ll be today, tomorrow or in two years. We know people have been talking about a fiscal crisis for a long time. Nothing’s really happened. So it does sound a bit like the story about the boy who cried wolf. And of course, in that story, the boy did get eaten by the wolf at the end. So, there is a final chapter. That’s not a very nice one. We just don’t know how far along in that story we are at the moment. What I would say is that this time is different in the sense, we have both very high levels of debt and also very high levels of interest payments on that debt, unlike in the past.
So, in your preference to underweight equities in the current context, one thing is the earnings estimate and the recession. How much would you give weightage for these macro-risks like threats posed by the bond market?
You should include it in your estimate of earnings as well as in your view of whether stocks will perform well or not, even if it’s not like a central scenario.
I think that’s actually a big problem with how financial markets and particularly how equity markets operate. If something’s not like a huge risk, equity markets tend to just ignore it. And so often, what happens is that a small risk will get bigger, bigger and bigger and then all of a sudden, it’ll reach a threshold where it’s too big to ignore. And then it goes from being something that’s completely irrelevant to something that is now the only thing that matters. And we saw that in many occasions, — 2007-08 crisis, during early stages of the pandemic and even with the trade war. It really wasn’t until Liberation Day that everything fell apart.
I think it’s dangerous to ignore these sort of risks, even if they’re not central risks.
So as long as this risk remains, would you suggest underweight equities or would you suggest it has to be balanced out if a recession is avoided?
In this industry, being early on a call is not really that different from being wrong on that call. You can have a great thesis, but if your timing is off, you still lose money. So, my recommendation right now is to modestly underweight stocks. I don’t think you want to be fully defensive at the moment. I think you only want to turn fully defensive, when the so-called whites of the recession’s eyes are visible, and they’re not visible yet.
But at the same time, I think the risks are high enough and I want to be prepared. I don’t want to be too overexposed to stocks at the moment, because you never know when that snowflake could hit the mountain and the avalanche begins.
For investors here who want to be alert to risks to their US equity investments that you have explained, can you suggest the three most important economic variables they need to track?
If you’re tracking data for the purpose of timing the business cycle, you need to stick to data that’s both leading in the sense that it tends to move before other data does and is also very timely.
Since you asked for three, I would suggest tracking the labour market, the housing market and consumer spending.
With regard to labour, besides the monthly payrolls and unemployment data, you want to look at initial unemployment claims as well as continuing claims. Initial claims have been ok, but continuing claims have been going up, suggesting that maybe we’ll get an increase in the unemployment rate over the next month or so because typically the unemployment rate and continuing claims move together.
On housing, there are a few series that are important to monitor. Building permits tend to be one of the most leading housing series. You need a permit before you can build a house. So what happens to building permits tends to impact housing starts and construction activity. That data has been fairly weak this year. Further, one should look at inventories of newly-built homes because those inventories will determine whether home builders continue construction projects. Inventories have been increasing quite a bit, especially in the southern States and that might cause construction activity to fall off.
And then within housing, I would look at home prices and we have a lot of data in the US — the Case Shiller index, Zillow, the FHFA index. Worryingly, those home price series have all rolled over. They’re all pointing to declining home prices across large parts of the US in recent months.
On the consumption side, you have to follow the monthly retail sales data. There are also like higher frequency measures of spending based on card data, based on kind of floor foot traffic in retail establishments. The Chicago Fed has this very nice series that tracks kind of these big data measures of retail sales.
The good thing about the US is there’s a lot of data. Some of it is better than others, but I think if you kind of focus on those three categories, you’re going to get a good read of what’s happening to the economy.
In your recent report, you’ve also given a bullish view on the yen, whether it’s the USDJPY or the EURJPY. Last August, when the yen rallied sharply, there was turbulence in the markets, albeit short-lived. If the yen appreciates strongly, is there risk of similar turbulence?
I think the yen carry trade is in the process of unwinding because Japanese rates are heading higher, whereas rates elsewhere are heading lower. And so that incentive to borrow in yen and buy higher yielding currencies has diminished. It’s true that last July/August the yen jumped, there was market turbulence and then it kind of fizzled. But that’s because back then, there was kind of this fear that the US was about to enter recession as unemployment rate had inched up. And that fear never materialised.
Our positive outlook on the yen stems from our view that it is around 40 per cent undervalued against both the US dollar and the euro, and over time that undervaluation will correct. I don’t know if it’ll be this year or next year, but I like to hold cheap assets that have potential catalysts, and the yen is one such asset. It’s cheap and it’s got the potential catalyst of a global downturn to send it higher. In the event of a global downturn, other central banks will be cutting rates aggressively. The Bank of Japan, which never really raised rates that much to begin with, won’t be able to cut rates aggressively. And so those rate differentials will move in favour of the yen, and that will help support the currency.
And at the same time, the Japanese hold a lot of assets abroad because they’ve been running these large current account surpluses for many, many years. Typically, what happens in a global downturn is that the Japanese repatriate some of those assets, bring them back to Japan, convert them into yen, and that puts upward pressure on the yen.
When you say it’s cheaper by a certain percentage, what is it based upon?
It is based upon the value of the currency in relation to its purchasing power parity (PPP) exchange rate. PPP exchange rates are exchange rates that equalise the price of a basket of goods and services across countries, sort of like the Big Mac index that The Economist has, but in this case applied to all prices. Based on that measure, the yen is about 40 per cent cheap in relation to the US dollar.
Lastly, coming to theme of the decade – your view on the AI craze all around and is the enthusiasm around the Magnificent 7 stocks justified?
This is really interesting because for a long time, people used to talk about how tech companies benefited from these capital-light models. But now, they have gone big on capex and expectation is that it will generate huge profits down the road. I’m a bit skeptical that will happen. Profits that tech companies earned from previous offerings such as social media isn’t going to be easily replicated with AI. For one thing, there’s no kind of clear network effect that exists in AI. I would say AI looks a bit like the airline industry where you’ve got a lot of companies producing a commoditised product. You could argue Gemini is better than ChatGPT or vice-versa, but you know they’re similar.
Commoditised product and high capex — that’s not really a good recipe for profitability. So, I do worry that at some point, there’s going to be kind of this realisation that the monopoly power that comes from some technologies might not come from AI. In which case, a lot of this investment may prove to have been unwarranted, at least based on a profitability point of view.