Equities and credit are pricing no risk of recession. And that could be problematic.
So suggested JPMorgan analysts led by Marko Kolanovic, who this week conceded that the defensive stance in the bank’s asset allocation model portfolio “has not played out,” leading to underperformance amid stubborn stock strength, soft landing euphoria and rate cut bets.
It’s not that JPMorgan thinks a soft landing is out of the question. Nor does the bank view “deep” rate cuts as impossible. Rather, it’s more that by now, those outcomes are priced into both equities and rates, which could cap upside even if the macro-policy trajectory evolves in line with the (rosy) consensus. On the other hand, “if the soft landing scenario does not play out as markets currently think, then there would be material downside,” Kolanovic and co. said.
The familiar (and updated) figure above shows the recession odds implied by difference assets. By way of explanation for those who haven’t seen that chart before, JPMorgan looks at historical cross-asset performance around recessions, and specifically at “the move from the pre-recession peak to the trough during the recession.” They assume there’s no recession risk priced at market peaks and that a downturn is fully priced at the lows.
Again: Equities and credit are sanguine. To the point that on JPMorgan’s simple calculation, stocks and corporate bonds see virtually no chance of recession.
Kolanovic (it’s actually JPMorgan’s house view) suspects core inflation outcomes won’t be as benign as some market participants are apparently inclined to believe during the first half of 2024.
“This call hinges on recent increases in shipping costs, an end to deflation in China and improving demand, which together would likely exert upward pressure on core inflation, in particular on core goods prices,” the bank said, adding that when “coupled with persistently elevated services inflation,” that could be a recipe for “a few” disconcertingly warm inflation prints. That, in turn, could “upset both bond and equity markets.”
But it’s not just macro speculation that has the bank cautious. The figure below shows revenue growth forecasts.
Given expectations for flat top-line growth, “one would have to assume continuous margin expansion to be able to project decent positive EPS growth in 2024 and 2025,” JPMorgan remarked.
As for EPS estimates, the bank’s skeptical. “Bottom-up analysts’ earnings estimate for 2024 EPS stands at $243 for the S&P 500, implying a PE multiple of above 20,” Kolanovic said, before suggesting the implied 11% profit growth for this year might be optimistic. Too optimistic.
“If we use a more realistic 2024 EPS of $220-$230, it would imply an even higher multiple of between 21-22 currently,” he added. The implication’s clear enough.
