“Until late summer, we thought corporate and consumer resilience [would] be able to withstand the significant increase of interest rates, wealth destruction and global geopolitical uncertainty,” JPMorgan’s Marko Kolanovic said Wednesday, explaining what, until late September, was a generally constructive outlook on risk assets, including stocks.
Two months ago (to the day), Kolanovic turned decisively cautious, citing, among other things, the risk of policy mistakes and geopolitical escalations. “As the expected peak in short-term interest rates moved from 3% to 5% and prospects for geopolitical de-escalation faded in early fall, we abandoned our positive view in the near-term,” Marko went on to say, in a note from his desk, on the way to cautioning that “overtightening” from central banks could lead to more weakness for the economy and markets.
Looking to 2023, there’s good news and bad news for stocks, Kolanovic said. The good news is that eventually, the Fed will pivot. The bad news is that the impetus for outright easing will have to come from some combination of unfortunate circumstances.
“Central banks will likely be forced to… cut rates sometime next year, which will result in a sustained recovery of asset prices, and subsequently the economy, by the end of 2023 [when] markets likely will focus on better economic and corporate fundamentals in 2024 and trade at levels higher than now,” he wrote, before warning that prior to cutting rates, the Fed will probably need to “see some combination of more economic weakness, an increase in unemployment, market volatility, decline in levels of risky assets and decline in inflation.”
The question, then, is how much pain the Fed wants to inflict in the service of chasing the inflation genie back into the bottle (or putting the toothpaste back in the tube, if you like that inflation metaphor better) before relenting.
For Kolanovic, stocks are likely to re-test the lows, particularly if there’s “a significant decline in corporate earnings” in conjunction with higher rates. In JPMorgan’s view, another market swoon “could happen between now and the end of the first quarter of 2023,” or even by the end of 2022.
The crucial point from Marko on Wednesday was that ultimately, ever tighter policy probably isn’t consistent with modern market structure, which, over the years, optimized around ZIRP, NIRP and LSAP, and “solved” (if you will) for the associated dearth of yield by way of leverage deployment.
The passage (below) is from Wednesday’s note, but it recalls vintage Kolanovic. I’ll present it without further editorializing:
The financial system over the past ~15 years evolved around an environment of near-zero interest rates. This includes leverage, functioning of arbitrage channels and strategies that rely on leverage, new models of liquidity provision, liquidity risk of private assets, systematic investing, etc. Together, these can give rise to a self-reinforcing feedback loop of volatility-liquidity-positioning. This type of market interdependencies, which are a feature of financial markets built around a near-zero rate environment, can cause selloffs such as the one at the end of 2018 and on a number of other occasions. These financial risks can lead to contagion and are not captured by low-frequency economics (e.g., ‘Phillips curve,’ etc.). In an environment of deteriorating fundamentals, quantitative tightening and an abrupt increase of interest rates, these risks could emerge much sooner than, for example, an increase in unemployment or decrease in inflation.
Please keep your comments professional.
I wonder if there has ever been a time where the outlook for a recession has been as clear as it is now, and at the same time the stock market has been as bullish as it has been recently.
I guess the assumption is that we live in an inflationary world. The Fed must start printing money again, sooner rather than later, otherwise the entire economy will break.
Although stocks may dip now, they will be MUCH higher two years from now (e.g. SPX 8000). So if you can simply wait it out, you will be well rewarded.
I don’t know how the Fed is supposed to control inflation, if they can’t also control leverage in the economy.
Yeah, I think it goes back to a combination of the dynamics described in “The Tragedy Of America’s $3.5 Trillion In ‘Extra’ Savings” and the ones above that Kolanovic is describing. The wealthy have done very well the past couple years. If the Fed is forced to cut interest rates due to some event even in the face of continued inflation or solid employment, the sky is the limit for the market. All that money will come flooding back in and I think it’ll be in search of solid companies (e.g. big tech) and real estate. I’d bet that the more speculative companies that have dropped 75%+ will have a much longer road back and many will still face bankruptcy.
Longer term, I think we are going to get whiplash from interest rates going up and down rapidly over the next decade as the Fed swings between trying to prevent economic collapse and fighting inflation. The only way I see us avoiding that is a significantly more progressive tax structure and a national housing policy, but I don’t see either of those two things happening.
Other than housing (admittedly not an insignificant sector) and various uber-speculative plays like crypto, SPACs, and 30X revenue stocks, where do we see severe pain or unbearable stress in the US economy? I mean, severe and unbearable to the Fed?
H-Man, I agree with Marko there will be a swoon but not this year or Q1 23. A better time candidate is Q2 or Q3 for the swoon when the earnings picture will be very clear and gloomy while inflation will appear to be very sticky with the market wondering how many 50 point bumps will it take. As we all know, it is all a matter of timing.
Seems likely to me the Fed will continue to hike methodically, albeit at smaller increments, until a market forces them to pivot. The Fact the Mr. Kolanovic has turned more cautious and sees a re-test of recent lows brings the view of many prominent analysts into somewhat consensus for 2023, higher rates and a hit to corporate earnings should provide fertile ground for more volatility, probably exacerbated by CTA and automated strategies. I personally expect we will breach recent lows in stock indices but I am betting longer duration US bonds have bottom here, recession fears and reality should dominate the narrative and create dispersion among companies and sectors as we see who gets hit harder. Anyway, I am not deploying cash in any meaningful way until the Fed actually pivots, nothing wrong with patience, cash and bonds the rest of 2022.