The stock market has been under pressure since last week’s surprisingly strong August inflation report, but JPMorgan Chase & Co. chief strategist Marko Kolanovic doesn’t see this year’s decline getting much worse than the hawkish one. Federal Reserve. .
“While we recognize that more aggressive central bank pricing and the resulting rise in real yields are weighing on risk assets, we also believe that any downside from here is likely to be limited,” Kolanovic said in a JPMorgan research note on Monday. “Strong earnings, low investor positioning and well-established long-term inflation expectations should moderate any downside bias in risk assets going forward.”
Investors are bracing for a jumbo rate hike from the Fed on Wednesday, the day central bank chief Jerome Powell holds a press conference on its latest policy decision as it battles high inflation. The S&P 500 is already down about 18% so far this year amid concerns about rising interest rates and the persistently high cost of living in the US
JPMorgan’s Kolanovic has a more bullish view of the stock market than some other investors and analysts on Wall Street, including warnings from Morgan Stanley that stocks could pull back and retest the 2022 low hit by S&P 500 in June.
Reading: ‘Some warped logic around valuation multiples’: Stock market investors appear complacent as interest rates rise, Morgan Stanley warns
Kolanovic acknowledges the weight of rising real yields and higher expectations for the Fed’s final rate in the market.
“The Fed’s top pricing, as implied by Fed funds futures, is at a new high of 4.5%,” or 50 basis points above the previous high in June, he said. “Real yields are also hitting new highs,” with the real yield on the 10-year Treasury note above 1 percent at nearly 210 basis points above its level at the start of the year, Kolanovic said.
Real returns are adjusted for inflation.
In Kolanovic’s view, bigger-than-expected corporate earnings this year are helping to soften the bearish situation for the stock market.
“Better-than-expected earnings growth reminds investors that equities represent a real asset class that offers protection against inflation and is therefore more attractive than nominal assets such as the vast majority of fixed income,” he said. “Even excluding energy, a sector that has clearly boosted earnings at the index level, the decline in earnings has been rather small so far.”
While the earnings cut could become more significant if the unemployment rate starts to move “substantially” higher and the US falls into a deep or prolonged recession, Kolanovic sees a potential backstop in the stock market.
“Even in this adverse scenario we believe the Fed would cut rates by more than is currently priced in for 2023, thereby reigniting equity markets and prompting higher price-to-earnings multiples,” he wrote.
Kolanovic also pointed to investor position as a mitigating factor to the downside, saying equity funds have lost more assets under management this year than they gained in 2021.
“In other words, retail investors are back to late 2020 levels in terms of their equity allocation,” he said. Meanwhile, “institutional equity positions are also low,” he wrote, as indicated by “proximating equity futures positions” as well as “persistently low demand for hedging.”
As for longer-term U.S. inflation expectations, Kolanovic noted that they have recently declined based on market measures as well as University of Michigan research.
“The stabilization of long-term inflation expectations reduces fears of a disengagement in US inflation expectations, making it easier for the Fed to pivot ahead in the scenario where labor market indicators weaken enough to confirm a US recession” , he said.
US stocks closed higher on Monday after a volatile 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, with its decision on interest rates expected on Wednesday afternoon.