The stock market has been under pressure since August’s inflation report came in surprisingly strong last week, but JPMorgan Chase & Co.’s chief market strategist Marko Kolanovic doesn’t see this year’s decline much uglier despite a tightening Federal Reserve.
“While we acknowledge that tighter central bank pricing and the resulting rise in real yields weigh on risk assets, we also believe any downside from here would likely be limited,” Kolanovic said in a JPMorgan research note on Monday. “Robust earnings, low investor positioning and well-anchored long-term inflation expectations should mitigate any downside in risk assets from here on out.”
Investors braced for a jumbo rate hike from the Fed on Wednesday, the day when Central Bank Governor Jerome Powell is to hold a news conference on its latest policy action to combat high inflation. The S&P 500 is already down around 18% this year on concerns about rising interest rates and the persistently high cost of living in the US
JPMorgan’s Kolanovic has a more optimistic view of the stock market compared to some other Wall Street investors and analysts, including Morgan Stanley’s warnings that stocks are heading for another slide and the 2022 low that the S&P 500 hit in June could test again.
Read: ‘Some twisted logic about valuation multiples’: Stock market investors seem complacent when rates rise, Morgan Stanley warns
Kolanovic acknowledges the weight of rising real yields and higher expectations for the Fed’s terminal rate on the market.
“Top Fed prices, as implied by Fed fund futures, are making new highs of 4.5%,” or 50 basis points above the previous high in June, he said. “Real yields are also making new highs,” Kolanovic said, with the real rate on the 10-year Treasury topping 1%, almost 210 basis points above its level at the start of the year, Kolanovic said.
Real returns are adjusted for inflation.
Kolanovic believes stronger-than-expected corporate earnings this year are helping to soften the downside for the stock market.
“Better-than-expected earnings growth is a reminder to investors that stocks are a real asset class that offer 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 significantly increased earnings in line with the index, the decline in earnings has been modest so far.”
While an earnings decline could become more significant if the unemployment rate starts to rise “substantially” and the US falls into a deep or protracted recession, Kolanovic sees a potential holdback in the stock market.
“Even in this adverse scenario, we believe the Fed would cut rates by more than what is currently priced in for 2023, thereby supporting equity markets and inducing higher” price-to-earnings ratios, he wrote.
Kolanovic also pointed to investor positioning as a mitigating factor on the downside, saying equity funds 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, indicated by “proxies for equity futures positions” and “continued low demand for hedging.”
As for longer-term inflation expectations in the US, Kolanovic noted that based on market measurements as well as the University of Michigan survey, they have recently declined.
“The stabilization in longer-term inflation expectations reduces fears that US inflation expectations could be unpegged, thus facilitating a dovish change of course by the Fed going forward in the scenario where labor market indicators weaken enough to trigger a US recession confirm,” he said.
U.S. stocks closed higher Monday after a choppy trading session ahead of the Fed’s two-day meeting with the Dow Jones Industrial Average DJIA,
up 0.6%, the S&P 500 SPX,
up 0.7% and the Nasdaq Composite COMP,
Increase of 0.8%.
The Federal Open Market Committee will begin its two-day meeting on Tuesday, with its rate decision expected on Wednesday afternoon.