Bear Market Bender

Risk sentiment looks poised to oscillate for the next several weeks.

Meandering price action will invariably be explained by reference to the purported “daily” ebb and flow of hard landing concerns. I’ll eschew the temptation to deride our collective penchant for retrofitting narratives, ex post, to “explain” why screens are green or red on any given day.

The bottom line is that, for the foreseeable future, it’ll be difficult to give rallies the benefit of the doubt. Rips should, and probably will, be sold. Until a US recession is everyone’s base case and earnings forecasts are cut to reflect a more challenging economic reality, calling a bottom in equities is a fool’s errand.

As UBS’s Keith Parker noted this week, the S&P’s forward multiple has contracted 28% in 2022, but forward earnings estimates are up nearly 8% (figure below).

This is well-worn territory by now, but the entirety of this year’s selloff is down to multiple contraction. Earnings estimates continue to creep higher despite a veritable cacophony of recession calls.

For their part, UBS is still constructive. Parker sees the bank’s earnings estimates for this year and next as “achievable,” but conceded that “risks are firmly to the downside.”

Some version of that assessment is a fixture of the daily news cycle: A bad outcome isn’t inevitable, but the risks are asymmetrical. Jerome Powell said as much during a difficult day of testimony on Capitol Hill Wednesday.

“With consensus forward four-quarter S&P EPS at $241 and our 2023 forecast for $250, market valuations look relatively cheap at around 15x,” Parker went on to say, before adopting a somewhat more cautious cadence in noting that US equities are currently trading at 17-18x trend earnings and 19-22x recession-level EPS. “What the market is clearly not discounting, in our view, is a recession-type scenario in which real yields stay elevated or well above zero,” he wrote.

To me, that latter point is a problem. With the Fed determined to get rates into restrictive territory and breakevens likely to come under pressure as the economy decelerates and commodities trim historic gains, real yields could easily stay positive while the economy downshifts. That’d be very challenging for equities (figure below).

Importantly, UBS noted that the trough in multiples typically doesn’t coincide with the trough in earnings. That’s worth keeping in mind as you work through different P/E-EPS permutations. Still, there’s a case to be made that multiples could contract a bit further, and it goes without saying that if a recession is indeed on the horizon, current EPS estimates need to come down materially.

Although Powell grabbed all the headlines Wednesday, Patrick Harker mentioned the prospect of a “couple of negative quarters” for the economy and said a softening in demand is “exactly” what the Fed wants.

On the bright side, Harker also suggested that balance sheet rundown may mean the Fed doesn’t have to hike rates as high as it otherwise might. “I don’t think we have to overreact in terms of raising the fed funds rate,” he said, during a panel discussion with Thomas Barkin. “We need to get above neutral -– I’d like to get above 3% — but I don’t think we have to accelerate rapidly beyond that at this point until we have a better understanding of what exactly the quantitative tightening is doing.”

This is all very dicey. I assume that’s obvious. Policymakers are flying almost completely blind, which means markets are too. After a decade spent anesthetized, the price discovery mechanism has atrophied. Without forward guidance, nobody knows what to do.

It doesn’t help that the mainstream financial media is on a bear market bender. The figure (below) shows the daily story count for the key phrase “bear market.” Plainly, stories about bear markets will proliferate when stocks officially close 20% from the highs, but I’d gently suggest that 4,750 in a day may be overkill.

I’ve contributed to that deluge. Perhaps I shouldn’t throw stones, residing in a glass house as I do.

Coming full circle, it’s easy to imagine a scenario where equities pinball between gains and losses between now and Q2 earnings. “It feels like the eye of the storm — that quiet moment when you’re tempted to believe the worst is over, but you know this is just a temporary respite,” SocGen’s Kit Juckes said.

It’ll be interesting to see how the first evidence of labor market normalization is greeted in the US. It’s a little too early for this call, but at some point, I’d expect to see a big downside surprise in the JOLTS headline. Ostensibly, such a development should be welcomed by markets, as it’d suggest one key supply-demand mismatch is on the way to resolving. But depending on the scope and speed of any meaningful decline in job openings, it could also portend a rapid deterioration in the labor market as employers come to terms with the reality of a looming recession.

Meanwhile, inflation will be uncomfortably high at least through year-end barring an extremely fortuitous (or, in the case of across-the-board demand destruction, extremely distressing) macro turn. “The trouble with the view that the worst of the market reaction to inflation/rate-hiking is behind us is that there’s so much more rate-hiking ahead,” Juckes wrote, in the same note mentioned above.

Speaking alongside Harker on Wednesday, Barkin conjured a delightfully tautological description of the Fed’s plight. “We need to do what we need to do to reinforce the message that we’ll do what it takes,” he mused.

In a strategy note, BNP wrote that last week’s 75bps hike from the Fed should be “viewed as another commitment to do ‘whatever it takes’ to fight inflation.” The bank continued: “Historically, once inflation is above 5%, a ‘whatever it takes’ approach has seen the Fed engineer a recession.”