Why Lazard's Ron Temple believes the earnings shoe is still yet to drop

When we last spoke in February, Lazard's Chief Market Strategist Ronald Temple had structurally higher inflation and earnings downgrades as core tenets of his base case. Although that view has not changed dramatically, one thing has certainly thrown a spanner in the works. 

The artificial intelligence (AI) frenzy has fuelled a 14% rally on the S&P 500 since that interview. Temple says that you cannot call the top on these stocks because there is just that much euphoria in the price. 

Temple joined me recently for an interview to refresh his macro views and the ways he is playing the vastly different opportunity set available in today's market.

It's all about the consumer

Like many other strategists, Temple has been caught pleasantly by surprise at the resilience of the US economy. Inflation continues to moderate and the July report demonstrated another step down in price increases. 

"I think the Fed is successfully threading the needle between reducing inflation and hopefully avoiding recession risk," Temple said.

But Temple has not moved his probabilities of a US recession very much (from 40% to 35%) in the last six months. That stands in stark contrast to other economists like Bank of America's Michael Gapen and JPMorgan's Michael Feroli, who both scrapped their respective recession calls last week. As for why Temple has not budged, it's simply because this time is different.

"We've never entered a rate hiking cycle within the immediate aftermath of a massive fiscal stimulus program," he said. 

"What still worries me is there is a chance that the economy has been so resilient just because people had so much cash in the bank when this all started. The longer rates stay high, the more you start to see the cracks in the foundation," he added.

Temple does not expect another rate hike this cycle but it doesn't mean that the end of tightening is in sight nor are rate cuts on the way.

"QT is still going on. The Fed's balance sheet has shrunk by $936 billion. It's pretty incredible that you can shrink a balance sheet that much and it doesn't seem to have affected markets materially. That will continue," Temple said. 

On the American equity market

Since our last interview in February, the S&P 500 has risen 14%. But on an equal-weighted basis, the rise is just 3% and outside of the AI basket of stocks, the index is more or less flat.

"To me, it's less of a story of whether the market is expensive and more of where do I want to rotate my money from," he posits.  

"Over the next six to 18 months, I don't see a lot of S&P 500 upside given the economic outlook and the earnings outlook. But I do think there could be a big rotation within the markets as enthusiasm or euphoria around generative AI might subside," he added.

Temple continues to stick firm to his thesis - have long positions in quality stocks but only buy in at reasonable valuations. But what does quality mean? Even within Lazard, teams approach this question of quality differently.

"One approach is to say quality is high returns on capital that can be sustained through the cycle. Another definition of quality might be strength and balance sheet and predictability of earnings, knowing that there might be a cycle to it," he said.

And while he didn't share any sectors where he is finding more of these than others, he did share some sectors where these kinds of companies are less likely to be found.

"You typically don't find a lot of quality in US utilities or in very unpredictable parts of the market like oil (energy) or metals and mining companies, where the commodity price volatility is so extreme that you can't predict the earnings. Banks are also typically not something you associate with quality," he said.

Outside the S&P 500

Temple is finding much more opportunity in three other jurisdictions - Japan, emerging markets, and UK large-caps. And all three are attractive for very different reasons.

Japanese stocks have been on a tear this year and Temple thinks that the TOPIX's 20%+ rally can continue.

"I think the earnings expectations are still too low. The changes in the rules from the Tokyo Stock Exchange earlier this year are really big. We're seeing record buybacks and record dividend payouts largely as a result of those rule changes. That means to me the "E" in the earnings expectations is too low," he said.

Across the emerging markets, Temple also continues to find opportunity in select companies and regions.

"[These countries are at the] end of the rate hiking cycle, we're seeing ROEs in EM equities go up over the last two or three years. And we're seeing the kind of growth gap between emerging market economies and developed market economies expanding in favour of EM," he said. "They are cheap and they have reasons to go up."

Finally, he is recommending that clients take a closer look at UK equities. British large-caps, in his view, are so cheap and sentiment is so negative that it might just be irresistible.

"The FTSE 100 probably is not where you need to be negative. If we avoid recession, if inflation continues to fall, and people start to think we're 90% or 100% of the way down on the heightening cycle, that market seems like one where you could have some pretty meaningful upside," he nominated.

And outside equities

Outside equities, Temple is finding more opportunities in sovereign (government-issued) fixed income. Yields in Australia and the US continue to hover around the psychologically important 4% level. And while Temple wishes yields would be a little higher (because price moves inversely to yield), he has become comfortable taking a closer look.

Outside of conventional fixed income, Temple looks to emerging market debt as well as convertibles. Convertibles are a special kind of asset (usually either a bond or preferred equity stake) that can be converted into common stock. These assets are not all that common in Australia but in the US, they can be used to provide downside protection and generate extra income along the way.