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The Global Stock Market Rally is About to Meet Recession Reality

Stock markets around the world have been rising on the expectation that central banks will start to ease up on interest rate hikes as inflation begins to level off. However, some analysts are not convinced that this rally will continue.

November 17, 2022
9 minutes
minute read

Stock markets around the world have been rising on the expectation that central banks will start to ease up on interest rate hikes as inflation begins to level off. However, some analysts are not convinced that this rally will continue.

Last week, markets were bolstered by news that U.S. inflation came in below expectations for October. This prompted investors to bet that Federal Reserve policymakers would soon have to slow or stop the monetary policy tightening measures they have deployed to try to bring down inflation. As a result, the S&P 500 notched its largest single-day gain since the early 2020 pandemic rebound rally.

However, Fed Governor Chris Waller said Monday that markets had overestimated the significance of a single data point, and that the U.S. central bank still has “a ways to go” on interest rate hikes. Waller noted that the Fed would need to see a sustained increase in inflation before raising rates further.

Several analysts have agreed that inflation may be more persistent than the market is currently pricing in. The BlackRock Investment Institute said in a note Monday that labor constraints driving wage growth and core inflation may be more persistent than the market is currently pricing in. This sentiment has been echoed by several other analysts in recent days.

Despite the recent stock market surge, which suggests that markets are reaffirming hopes of a soft landing from the Fed, BlackRock's top strategists disagreed. They remain underweight developed market stocks.

"Equities have repeatedly jumped this year on hopes that the Fed may be getting closer to stopping the fastest hiking cycle since the 1980s, which would allow the economy to enjoy a soft landing and avoid recession," said Head of the BlackRock Investment Institute Jean Boivin and his team.

We believe that the hopes for a rebound in the stock market will be dashed as the Federal Reserve continues to tighten monetary policy. With the S&P 500 index up 13% from its October low, stocks are even further from reflecting the recession and earnings downgrades that we expect in the future.

BlackRock is expecting downward surprises due to earnings downgrades. While consensus expects earnings growth to fall from 10% at the start of 2022 to just over 4% in 2023, BlackRock expects zero growth. They note that third-quarter annual earnings growth would already be in negative territory without the huge windfalls seen in the energy sector.

According to Boivin's team, stocks need to fall further or there needs to be more good news on inflation before they will become positive on stocks.

At the Sohn London Investment Conference on Wednesday, Dan Avigad of Lansdowne Partners said that as central banks take steps to suppress demand and keep inflation in check, corporate profit margins will have to come down from their current high levels. Avigad noted that this will have an impact on stock prices and investment strategies.

According to Avigad, earnings for the stock market are currently running about 20% above the long-term trend. This suggests that earnings estimates for the market may be overestimated by 15-20%.

Last Thursday's rally on Wall Street was one of the 15 biggest single-day gains for the S&P 500 since the mid-1960s, according to Capital Economics. Senior Markets Economist Thomas Mathews said in a note Monday that there is a case for further gains if falling inflation leads to the end of monetary tightening. However, the economic research firm is still downbeat on equities due to risks to the growth and earnings outlook.

Capital Economics has forecast a mild recession in the United States, as well as contractions in several major developed markets. According to Mathews, this macroeconomic outcome has not been fully discounted by equity markets, as evidenced by consensus earnings expectations.

Mathews admitted that the valuation of the U.S. stock market has fallen a long way. He noted that this is also the case with stock markets in other countries. However, he pointed out that the experience of U.S. recessions in the recent past is that the price/estimated earnings ratio of the S&P 500 falls a bit further around their onset, even if it was already low due to previous rate hikes and despite falls in real safe asset yields.

This suggests that the sustainability of the latest rally depends at least as much on incoming data on economic growth and corporate profits as it does on inflation.

Capital Economics is forecasting that earnings will disappoint the market and weigh further on stocks, with the S&P 500 falling to a trough of 3,200 by the middle of 2023, around 20% below its current level. Other global equity markets are expected to decline by similar amounts.

However, not everyone shares this view. Patrick Spencer, vice chairman of equities at Baird, told CNBC that he had yet to see anything in the data that suggested a U.S. recession was on the cards. Spencer suggested that last week’s inflation data indicates that the economy is looking at a “soft landing.”

"Equities trade on earnings revisions, and most of the discussion is that we're expecting a severe recession in the U.S. However, there is no evidence of this happening at the moment," Spencer said.

"We continue to believe that the company's earnings revisions and earnings are still solid, both in Europe and even in the UK when considering the valuation. The same can be said for the US market. Therefore, we would still stand behind that argument."

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