US and European stocks have steadily recovered over the past two months, repairing some damage of the 2022 bear market. Yet some of the world’s biggest asset managers remain to be convinced the recent strength will last.
Wall Street’s benchmark S&P 500 index was up 13 per cent from its recent low point before US markets closed for Thanksgiving on Thursday. Europe’s continent-wide Stoxx 600 has risen even more. October and November are on track to register the first consecutive months of gains since 2021.
Investors are wary of celebrating, however. Instead, they see further dangers from the Federal Reserve as the US central bank raises interest rates to bring down persistent inflation. Many economists are forecasting an economic downturn that would cut into corporate profits.
“Markets are hoping that inflationary pressure will just magically disappear,” said Wei Li, chief investment strategist at BlackRock, the world’s largest asset manager. “It’s only a matter of time until the message [from the Federal Reserve] sinks in again and the reality of recession sinks in.”
The Fed’s efforts to tame inflation through higher interest rates have been the main driver of falling stock prices this year, and hope that the worst price rises are over has helped to sustain the recent turnround. The biggest jump came on November 10, when the S&P 500 leapt 5.5 per cent after the US reported a more gradual inflation rate than economists expected.
The prospect of cooler inflation has led investors to bet that the Fed would not need to raise rates as much as previously forecast, in turn boosting the relative value of companies’ future earnings. The S&P 500 added another 0.6 per cent on Wednesday after minutes from the Fed’s largest policy meeting revealed most officials favoured slowing down rate increases after four 0.75 percentage-point boosts in a row.
Interest rate futures markets, which have a strong bearing on stock price moves, are currently forecasting several rate cuts after a peak next spring. The Fed minutes did not reveal debate over lowering benchmark rates, however, and officials have stressed that they will remain high for an extended period.
“We can probably rally through the next data cycle [in December] but in the new year, when people realise cuts aren’t coming soon, the reality of inflation” will be more apparent, predicted Dan Gerard, multi-asset strategist at State Street.
Some investors believe that markets are not reflecting enough of a hit to corporate profits from higher borrowing costs and a weaker economy. Analysts expect that earnings across the S&P 500 member companies to grow by 5.7 per cent next year, according to FactSet, despite the threat of recession.
Analysts who focus on individual companies “have been slower to react to a fast-changing macroeconomic landscape,” said Li of BlackRock. “Seeing earnings-forecast capitulation and that being priced in is one of the signals I would look for us to become more constructive on our equity views.”
In Europe, the continent-wide Stoxx 600 is up 15 per cent from its low at the end of September. French and German markets have strengthened more.
As in the US, investors worried over inflation have recently had some better news, with German producer prices falling for the first time in two years. Economists are still predicting a downturn, but falling prices for natural gas — which hit an all-time high in August — have helped to soften economic forecasts.
The region is also poised to benefit amid rumours that China could begin reopening to the rest of the world in early 2023.
Seema Shah, chief global strategist at Principal Asset Management, told an FT conference in November that German companies look “screamingly attractive” from a valuation perspective.
Developments this week have highlighted risks, however. Several cities in China were plunged back into lockdowns as Covid-19 cases in the world’s second-largest economy approached record levels, while Russia threatened to restrict gas supplies to western Europe.
“We’ve priced out the tail risk of blackouts and energy rationing, but European equities look overbought,” said Tim Drayson, head of economics at LGIM. “Fundamentally, the profits picture is still really bleak. I don’t expect this rally to last”.
Still, while many investors are cautious about the longer-term picture, some believe the current rally has time to run.
Andrew Slimmon, senior portfolio manager at Morgan Stanley Investment Management, said the sharp jump after the latest US inflation data means few investors would risk selling before the next release in mid-December.
Cash buffers built up by companies and consumers, and corporate reorganisations during the pandemic, mean earnings may hold up for longer than the biggest bears predict, even if they have to fall eventually.
“I think the market will rally into year-end and people will say, ‘Wow, that year wasn’t as bad as it felt like it was going to be’ . . .[but] then 2023 might be very similar to this year,” Slimmon said.
“The previous bear market was such a ‘V’. [Stocks] went down and came roaring back,” he said. “I think this one is going to exhaust people.”
Additional reporting by Jennifer Hughes in New York