The stock market has been under pressure since the inflation report for August came in extremely strong last week, but JPMorgan Chase & Co. chief market strategist Marko Kolanovic doesn’t see this year’s fall being much uglier despite a hawkish Federal Reserve. .
“While we recognize that more hawkish central bank prices and the resulting rise in real yields are weighing on risk assets, we also believe that any downside from this would be limited,” Kolanovic said in a JPMorgan research note on Monday. “Strong earnings, low investor positioning and well-established long-term inflation expectations should mitigate any downsides in risk assets from here.”
Investors are preparing for a jumbo rate hike from the Fed on Wednesday, the day central bank chief executive Jerome Powell will hold a press conference on his latest policy decision as he fights high inflation. The S&P 500 is down about 18% so far this year amid concerns about rising interest rates and the continued high cost of living in the US.
JPMorgan’s Kolanovic has a more positive view of the stock market than some other Wall Street investors and analysts, including warnings from Morgan Stanley that equities could take another leg off the lows the S&P 500 hit in 2022 in retry June.
Read: ‘Some logic about valuation multiples’: Stock market investors appear complacent as rates rise, says Morgan Stanley
Kolanovic acknowledges the weight of rising real yields and higher expectations for the Fed’s terminal rate on the market.
“Peak Fed prices as implied by Fed funds futures are making new highs of 4.5%,” or 50 basis points above the previous high in June, he said. “Real yields are also showing new results,” with the real rate on the 10-year Treasury note passing 1% at nearly 210 basis points above its level at the start of the year, Kolanovic said.
Real results are adjusted for inflation.
In Kolanovic’s view, stronger-than-expected company earnings this year help mitigate the downside for the stock market.
“Better-than-expected earnings growth is reminding investors that equities are a real asset class that offers protection against inflation and are therefore more attractive than nominal assets, like the vast majority of fixed income ,” he said. “Even if we exclude energy, a sector that has clearly increased earnings at the index level, the decline in earnings so far has been minimal.”
While the decline in earnings could become more significant if the unemployment rate starts to move “materially” higher and the US falls into a long or prolonged recession, Kolanovic sees the potential for the stock market to suffer.
“Even in this adverse scenario we believe the Fed would be cutting rates more than currently priced into 2023, which would dampen equity markets and lead to higher price-to-earnings multiples”, a he wrote.
Kolanovic also cited investor positioning as a mitigating factor on the downside, saying equity funds have lost more assets under management this year than they gained in 2021.
“In other words, retail investors have moved back to late 2020 levels in terms of their equity allocation,” he said. Meanwhile, “institutional investors’ equity positions are also low,” he wrote, as reflected by “proxies for equity futures positions” as well as “continued low demand for hedging.”
As for longer-term inflation expectations in the US, Kolanovic noted that they have declined recently based on market measures as well as a University of Michigan survey.
“The stabilization in longer-term inflation expectations reduces fears of a de-anchoring of US inflation expectations, making the Fed’s dovish pivot easier going forward if labor market indicators weaken enough to confirm a US recession,” a he said.
US stocks closed higher on Monday after a choppy trading session ahead of the Fed’s two-day policy meeting, with the Dow Jones Industrial Average DJIA,
climbing 0.6%, the S&P 500 SPX,
gaining 0.7% and the Nasdaq Composite COMP,
The Federal Open Market Committee will begin its two-day meeting on Tuesday, and its rate decision is expected on Wednesday afternoon.