“How can this possibly end well?”, America’s largest bank wondered, in a new note.
It was a rhetorical question. JPMorgan’s strategists do, in fact, expect things to “end well,” or at least not to end poorly.
The allusion to unfavorable circumstances followed a lengthy discussion of prevailing macro and micro challenges, which together have made it difficult for risk assets, and particularly equities, to sustain a bid in 2022.
On the macro front, the obvious headwind is hawkish central banks, and the precarious tightrope walk associated with normalizing policy to control inflation even as growth looks poised to slow.
JPMorgan’s strategists, led by Marko Kolanovic, seem to be in the “soft landing” camp. The ingredients for a recession “are not there,” the bank said, noting that their recession probability model isn’t flashing red, private sector balance sheets are “healthy” and “there are still some tailwinds to demand growth as disruptions associated with COVID continue to fade this year.”
Apparently, the probability of a recession in the near-term is somewhere close to zero (figure above).
Beyond that, the bank noted that inflation is still likely to moderate and besides, the Fed could always reverse course in the event it turns out the economy (and markets) simply can’t handle a relatively aggressive hiking cycle.
Further, you could argue markets have already passed the test. January was evidence that an abrupt hawkish turn and a dramatic repricing of Fed expectations isn’t the end of the world. At the index level, the correction was wholly pedestrian.
Indeed, even those skeptical of the notion that clear skies lie just ahead will admit that January could’ve been far worse. “It’s tempting to think that this is the end of the story: The test arrived early this year, and the markets passed,” Morgan Stanley’s Andrew Sheets wrote, before suggesting the real challenge for markets will be digesting a $2 trillion contraction in central bank balance sheets.
JPMorgan’s view is less foreboding. “While the direction of travel for central banks is that of normalization, this will also be the case for global inflation which we see moderating as supply constraints ease in 2022,” the bank said. “In addition, there is always the possibility of central banks hitting the pause button if they take things too far.”
And there it is again: Many market observers are reluctant to countenance the notion that the vaunted “Fed put” is truly dead, or even struck far below spot. My own view is that the Fed would, in fact, accept a deep drawdown in equities as long as it played out gradually and didn’t spill over into credit.
That said, I doubt officials have the stomach for a disorderly selloff. The impact on sentiment alone would argue for verbal intervention given the potential for consumers to believe a stock market crash might further erode their capacity to ride out the inflation storm. There’d be more than a little irony in a Fed that takes an early break from fighting inflation to rescue the stock market on the excuse that consumers can’t handle it. After all, stock rallies are conducive to the kind of easy financial conditions that facilitate inflation. And high inflation is the proximate cause of consumer angst.
In any case, Kolanovic and co. went on to suggest that “Powell’s hawkishness and the ensuing correction has inoculated the market to accept rate hikes going forward.” They also noted that Beijing’s efforts to bolster the world’s second-largest economy could serve as an offset of sorts.
On the micro front, JPMorgan flagged a very onerous environment for companies that fail to meet expectations. “The reaction function of the market has grown more punishing with regard to beats versus misses,” the bank remarked, adding that the situation is especially severe when juxtaposed with “decent earnings results.”
Some of it can be explained by “the big hit to net guidance,” which is in turn attributable at least in part to Omicron, and thereby may prove fleeting.
Further to the micro, Kolanovic noted that “one positive of a post-QE world with more reasonable real rates, is markets rewarding fundamentals more than future growth prospects.”
That’s a proposition that everyone can probably get on board with. It would be nice (to say the least) if investors could get a positive inflation-adjusted return on their cash, and it would be equally appealing if it were possible for companies that actually make things and turn a profit doing it to have some hope of matching the performance of profitless “theme” stocks.
Overall, JPMorgan sees volatility subsiding, which should be accompanied by the resumption of inflows from systematic cohorts, alongside the return of the corporate bid as buyback blackouts roll off.
“Hiccups and jitters in the early days in a hiking cycle are normal,” Kolanovic, Nikolaos Panigirtzoglou and Bram Kaplan said. “Risk markets can eventually get through these and worry about the punch bowl later.”
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