Too early to plough back into stocks: JPMorgan

Strategists at US investment bank JPMorgan see a mix of good and bad news for shares in 2023.

JPMorgan strategists see both good and bad news for shares in 2023.

Until September, they thought corporates and consumers could cope with rapidly rising interest rates, wealth destruction, and global geopolitical uncertainty since the start of the year.

But as the expected peak in short-term US rates rose from 3 to 5 per cent after a hawkish Jackson Hole speech from Fed chair Jerome Powell and an upside surprise to US CPI data, and as hopes of geopolitical de-escalation faded, they abandoned their view of the short-term outlook.

Since then, they’ve warned of weakness in markets and economies as a result of central bank “overtightening”. They feel rallies in shares are unsustainable without rate cuts by central banks, and they don’t see that happening without significant economic or market weakness.

After falling 19 per cent from mid-August to mid-October, the S&P 500 has rebounded 17 per cent, almost matching a 19 per cent rebound from mid-June to August. The S&P 500 also regained its 200-day moving average for the first time since April.

The Dow Jones Industrial Average has formed a technical bull market, rising more than 20 per cent from its October low. But the Nasdaq also formed a bull market when it rose 23 per cent in the two months to mid-August. It then dived 23 per cent to October and has risen 13 per cent since then.

Australia’s S&P/ASX 200 has risen 14 per cent since the Reserve Bank slowed the pace of rate hikes. Lower than expected monthly CPI data gives hope of an even smaller RBA hike next week.

But while Powell conceded again this week that US rate hikes may slow this month – sparking a 3.1 per cent rally in the S&P 500 as traders expected something more hawkish – JPMorgan doesn’t think a slowdown in rate hikes gives a green light to buy shares.

“There is good and bad news for equity markets, and more broadly risky asset classes, in 2023,” said the US investment bank’s head of global markets strategy, Marko Kolanovic.

The good news is that central banks will likely be forced to cut rates sometime next year, sparking a sustained recovery of asset prices, and subsequently the economy, by the end of 2023.

That could lead markets to expect better economic and corporate fundamentals in 2024.

The bad news is that this will require central banks – primarily the Fed – to cut rates. Getting to that point will require some combination of more economic weakness, higher unemployment, market volatility, lower share prices, and less inflation. Most of these will cause or coincide with downside risk in the near term.

JPM’s view on risk asset markets in 2023 consists of two periods – “market turmoil and economic decline” forcing interest rate cuts, and “subsequent economic and asset recovery”.

The exact path will depend on the depth of the correction in markets and economic activity that leads the Fed to “pivot” to cuts, and the point in time next year that such a pivot occurs.

In any case, Kolanovic thinks the October lows in shares will be retested. He sees a sharp fall in corporate earnings – implying lower price-to-earnings valuations and lower shares prices relative to the October 2022 lows.

He expects a sell-off in shares before the end of the first quarter of 2023. “Indeed, one can imagine market turmoil as soon as at the end of this year similar to the 2018 episode of quantitative tightening and manufacturing recession, or a sell-off after a weak quarterly earnings season in February next year,” he says.

A mitigating factor for a near-term sell-off is the continued “low positioning” in risk assets.

Consumer and corporate resilience may push out the “downside market scenario to late 2023”.

Or a sharp fall in inflation could prompt the Fed to pivot without much economic damage.

But apart from the impact of higher interest rates on consumer spending and housing, and a shift to bonds as rates rise and earnings fall, there’s an even bigger reason why central banks are likely to induce market turmoil and be forced to reverse course again.

Kolanovic says the financial system in the past 15 years has evolved around an environment of near-zero rates – including leverage, functioning of arbitrage channels and strategies that rely on leverage, new models of liquidity provision, liquidity risk of private assets and, systematic investing. The result is a “self-reinforcing feedback loop of volatility-liquidity positioning”.

This type of market interdependency, a feature of markets built around a near-zero rate environment, can cause sell-offs like the one at the end of 2018 and on a number of other occasions

“These financial risks can lead to contagion and are not captured by low-frequency economics,” Kolanovic says. “In an environment of deteriorating fundamentals, quantitative tightening and an abrupt increase of interest rates, these risks could emerge much sooner than, for example, an increase in unemployment or decrease in inflation.”

The path of the US dollar, correlated with nearly all assets, will be key. He expects the dollar to fall when the Fed cuts, sparking a more sustained rise in risk assets.

He maintains that commodities are in a “supercycle”, and any further pullback should be bought, as the structural supply-demand imbalance will persist for years, and a turn in the US dollar and recovery – especially in China – will add to the bull case.

Despite the recent rally, he sees European assets as being at risk from recession, energy crisis and war in the east, which he doesn’t see being resolved soon.

He remains positive on China, due to favourable monetary and fiscal conditions, as well as an eventual full Covid reopening.

The recent crisis of crypto schemes is “likely not over”, and its end will put additional pressure on risk sentiment and consumers.