Pessimism prevails as stock market sages look to 2023

The traditional Santa Claus rally on Wall Street may have fizzled out before December even started.

The S&P 500 index, arguably the world’s most influential stocks index, staged an impressive 17 per cent rebound in the six weeks to the end of last month. That followed a 27 per cent slump over the first 9½ months of the year. It has since run out of steam though, with stocks down so far this month.

Recession trades are back on. Economic soothsayers polled by Reuters this week are putting a 60 per cent probability on a US recession next year, even as the Federal Reserve is expected to ease back on rate hikes.

The consensus view is that the Fed will increase rates by half a percentage point next week, bringing its federal funds rate to 4.25-4.5 per cent. This follows successive 0.75-point increases in each of its last four rate-setting meetings – leading the way among major central banks globally as they seek to tackle soaring inflation.

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Over on US debt markets a powerful recession indicator that has been flashing red for months is now at levels last seen in the early 1980s. The market interest rate, or yield, on 10-year US government bonds is now about 0.8 percentage points lower than on two-year notes.

This phenomenon – known as an inverted yield curve – goes against normal market conditions where buyers of long-term bonds would expect higher interest rates than those who invest for a shorter period. It stands to reason that in an environment where the economy and inflation are expected to grow over the long term that investors would expect higher rates the longer their money is tied up.

When the normal relationship between short- and long-term rates is upended, however, it is an indication that investors expect the economy to contract soon and that the Fed will need to cut rates to help it out. Yield-curve inversion has preceded every US recession since the 1960s.

A flurry of 2023 stock-market outlooks that have been pushed out by investment banks and securities firms to clients are read-through-your-fingers pieces.

Goldman Sachs chief executive David Solomon said this week that he expects US stocks to continue to slide into next year as he put odds of the world’s largest economy pulling off a “soft landing” at only 35 per cent.

“I would define a soft landing as we get inflation back close to 4 per cent inflation, maybe we have a 5 per cent terminal rate and we have 1 per cent growth,” Soloman said.

A terminal rate refers to the level at which the Fed is expected to stop raising interest rates. Consumer price inflation in the US was running at an annual rate of close to 8 per cent in October. Figures out on Friday showed that producer prices rose by a greater-than-expected 7.4 per cent in November.

Morgan Stanley chief investment officer Mike Wilson, one of the more bearish strategists out there, reckons the S&P 500 could fall by as much as 24 per cent from current levels, to as low as 3,000, during the first quarter of 2023, as even beaten-down market expectations for corporate earnings remain way too high.

Even though Wilson predicts a market rally as the year progresses, he still sees the benchmark index recovering only to close to current levels.

European shares

Over on this side of the Atlantic, the consensus view among 14 strategists polled by Bloomberg this week is that the pan-European Stoxx 600 index will end 2023 little changed from current levels – with further losses in the first half of the year followed by a recovery in the second.

It follows an 11 per cent decline by the European index so far this year, driven by the Ukraine war-fuelled energy crisis, wider runaway inflation and the European Central Bank’s efforts to rein in consumer prices through rate hikes.

The fact that European shares are trading at a near record 30 per cent discount to US peers, relative to corporate earnings forecasts, isn’t tempting many to recommend that clients make a switch, given nervousness that estimates are likely too optimistic.

But some market observers are beginning to posit that recency bias – the tendency for people to overweight new information or events – may be clouding analysts’ outlooks a bit too much.

“Pessimism is seductive, and especially so when we look ahead to 2023,” Deutsche Bank director of thematic investment research Luke Templeman said in a report sent to clients this week.

“The yield curve is hideously inverted, recession is coming and stock markets usually bottom only after a recession has started. But when the outlook is overwhelmingly negative and no one is positioned for good news, markets can bounce on any unexpected positives that do arise.”

He highlights a number of potential triggers, such as inflation falling more quickly than expected, China adding stimulus to its economy following an easing of strict zero-Covid measures, or the possibility – however remote – of the Ukraine war coming to an end.

“Given there are several scenarios where good news on big events could occur in 2023, that makes for the unappetising decision for investors,” Templeman said. “Should they chase what may be another bear market rally? Or will any positive boost finally be the real deal?”