Proactive Investors - JP Morgan says the S&P 500 is likely to re-test the lows of 2022 this year as global growth slows to around 1.6%. However, a pivot from the US Federal Reserve could drive an asset recovery later in the year.
In its 2023 Market Outlook, the US bank's Global Research division cited tightening financial conditions, China’s policy response as the winter aggravates COVID in that country, and Europe’s persistent natural gas problems for the expected weak economic growth.
While the bank maintained that the global economy is not at imminent risk of sliding into recession as the sharp decline in inflation will help to promote growth, its baseline view assumes a US recession is likely before the end of 2023.
“There is good and bad news for equity markets and more broadly risky asset classes in 2023. The good news is that central banks will likely be forced to pivot and signal cutting interest rates sometime next year, which should result in a sustained recovery of asset prices and subsequently the economy by the end of 2023,” said JP Morgan’s chief global markets strategist and co-head of global research, Marko Kolanovic.
“The bad news is that in order for that pivot to happen, we will need to see a combination of more economic weakness, an increase in unemployment, market volatility, decline in levels of risky assets and a fall in inflation. All of these are likely to cause or coincide with downside risk in the near term,” he added.
Financial conditions drag
Following the deepest global downturn on record followed by the strongest rebound between 2020 and 2021, JP Morgan Research said 2022 was a “shocking year.” Contributing to the turbulence were supply and demand issues spilling into labor markets, a third major wave of COVID and Russia’s invasion of Ukraine.
As 2023 gets underway, the bank said monetary policy tightening drag is building and central banks remain on the march. Of the 31 countries it tracks, 28 have raised interest rates with more likely to come, it said.
Based on its current guidance, the Fed will have delivered a cumulative adjustment of close to 500 basis points on rates through the first quarter of 2023, JP Morgan Research said. The rise in borrowing costs is already weighing on housing activity while the sharp climb in the US dollar is likely weighing on US corporate profit margins, it added.
However, the financial conditions drag is being cushioned by a fading of supply chain and commodity price shocks, according to JP Morgan’s head of economic and policy research Bruce Kasman.
That will contribute to global consumer price index (CPI) inflation slowing toward 3.5% in early 2023 after approaching 10% in the second half of 2022, the bank said.
“Circumstances warrant considering a range of scenarios,” Kasman added. “The dominant event across different scenarios presented is a US recession … but the timing of this break, the path of Fed policy and the reverberations for the rest of the world vary.”
Equities likely to get worse before recovering
After a year of macroeconomic and geopolitical shocks in 2022, JP Morgan said investors responded by derating the S&P 500 price-to-earnings (P/E) ratio as much as seven times, while some speculative growth segments crashed 70-80% from highs.
And although fundamentals were resilient throughout these shocks, it said the constructive growth backdrop is not expected to persist in 2023, with fundamentals likely to deteriorate as financial conditions continue to tighten and monetary policy turns even more restrictive. The US economy is also likely to enter a mild recession, with the labor market contracting and the unemployment rate rising to around 5%, the bank said.
“Consumers with a cushion of savings from lockdown have mostly exhausted their post-COVID excess cash and for the first time are getting hit by a broadening negative wealth effect from all assets simultaneously — whether that’s housing, bonds, equities, alternative/private investments or crypto,” said Dubravko Lakos-Bujas, global head of equity macro research at JP Morgan.
“This proverbial snowball should continue to gain momentum next year as consumers and corporates more meaningfully cut discretionary spending and capital investments,” he added.
As a result, JP Morgan Research said it is reducing its below-consensus 2023 S&P 500 earnings per share of $225 to $205 due to weaker demand and pricing power further margin compression and lower buyback activity. It said the upside and downside to this base case will largely depend on the depth and length of the recession and the speed of the Fed’s counter-response. Market volatility is also set to remain elevated, with the Volatility Index or VIX averaging around 25.
“In the first half of 2023, we expect the S&P 500 to re-test the lows of 2022 as the Fed overtightens into weaker fundamentals,” Lakos-Bujas said.
“This sell-off combined with disinflation, rising unemployment and declining corporate sentiment should be enough for the Fed to start signaling a pivot, subsequently driving an asset recovery and pushing the S&P 500 to 4,200 by year-end 2023.”
UK the top pick among international markets
JP Morgan said it expects the convergence between US and international markets to continue this year, both on a US dollar and local currency basis as the S&P 500 risk-reward relative to other regions remains unattractive.
Although continental European equities have a likely recession to negotiate and geopolitical tail risks, it said the eurozone has never been as attractively priced versus US equities, while Japan should be relatively resilient due to sold corporate earrings from the economy’s reopening, attractive valuations and smaller inflation risks compared with other markets.
“Within developed markets, the UK is still our top pick,” said Mislav Matejka, head of European and global equity strategy at JP Morgan.
“As for EM (emerging markets), its recovery is mostly linked to China. Tactically, the Asia reopening trade led by China is overdue and the activity hurdle rate is very easy, with further policy support likely. We expect around 17% upside for China by the end of 2023,” he added.