The global stock market rally could be about to meet recession reality

Global stock markets have rallied on hopes that central banks will soon begin to slow their aggressive interest rate hikes as inflation shows signs of peaking, but strategists are not yet convinced the bounce has legs.

Markets were buoyed last week after U.S. inflation came in below expectations for October, prompting investors to bet that Federal Reserve policymakers would soon have to slow or stop the monetary policy tightening measures they have deployed to try to bring down inflation. The S&P 500 notched its largest single-day gain since the early 2020 pandemic rebound rally.

However, Fed Governor Chris Waller said Monday that markets had overestimated the significance of a single data point, and that the U.S. central bank still has “a ways to go” on interest rate hikes.

Several analysts have echoed that sentiment in recent days. BlackRock Investment Institute said in a note Monday that labor constraints driving wage growth and core inflation may be more persistent than the market is pricing.

Though surging stocks suggest markets are reaffirming hopes of a soft landing from the Fed, BlackRock’s top strategists disagreed, and remain underweight developed market stocks.

“Equities have repeatedly jumped this year on hopes the Fed may be getting closer to stopping the fastest hiking cycle since the 1980s, letting the economy enjoy a soft landing that avoids recession,” said Head of the BlackRock Investment Institute Jean Boivin and his team. 

“We think those hopes will be dashed again as the Fed pushes ahead with policy overtightening. With the S&P 500 jumping 13% from its October low, stocks are even further from pricing in the recession — and earnings downgrades — we see ahead.”

Central to the downward surprises expected by BlackRock are earnings downgrades. While consensus expects earnings growth to fall from 10% at the start of 2022 to just over 4% in 2023, the world’s largest investment manager expects zero growth, noting that third-quarter annual earnings growth would already be in negative territory without the huge windfalls seen in the energy sector.

“We need to see stocks fall more, or more good news of easing inflation, to turn positive on stocks,” Boivin’s team said.

These sentiments were echoed on Wednesday by Dan Avigad, partner and portfolio manager at Lansdowne Partners, who told CNBC at the Sohn London Investment Conference that as central banks look to suppress demand in order to tame inflation, corporate profit margins will also have to compress from their current “very elevated levels.”

“We’re still running around 20% above the long-term trend in terms of earnings, if we look back on trends for decades, and so it seems quite likely to me that earnings trajectories are being overestimated for the wider stock market perhaps by as much as 15-20%,” Avigad said.

Last Thursday’s Wall Street rally was the 15th-largest single-day gain for the S&P 500 since the mid-1960s, according to Capital Economics. Senior Markets Economist Thomas Mathews said in a note Monday that although there was a case at face value for further gains if falling inflation does lead to the end of monetary tightening, the economic research firm was still clinging to a downbeat view of equities amid risks to the growth and earnings outlook.

Capital Economics expects a mild recession in the U.S. and contractions across several major developed markets, a macroeconomic outcome that Mathews suggested has not been fully discounted in equity markets judging by consensus earnings expectations.

“Admittedly, the valuation of the U.S. stock market has now fallen a long way (as have the valuations of stock markets elsewhere, but the experience of U.S. recessions in the recent past is that the price/estimated earnings ratio of the S&P 500 fell a bit further around their onset, even if it was already low due to previous rate hikes and despite falls in real safe asset yields,” Mathews said.

“All this suggests to us that the sustainability of the latest rally depends at least as much on incoming data on economic growth and corporate profits as it does on inflation.”

For now, though, Capital Economics sees earnings disappointing the market and weighing further on stocks, forecasting the S&P 500 will fall to a trough of 3,200 by the middle of 2023, around 20% below its current level, with other global equity markets declining by similar amounts.

Not everyone shares this view, however. Patrick Spencer, vice chairman of equities at Baird, told CNBC that he had yet to see anything in the data that suggested a U.S. recession was on the cards, and suggested that last week’s inflation data indicates that the economy is looking at a “soft landing.”

“Equities trade on earnings revisions and the majority of the dialogue is that we’re looking for a steep recession in the U.S., and it just isn’t there at the moment,” Spencer said.

“Its earnings revisions and earnings still look okay, both in Europe, and even in the U.K. given the valuation, and the U.S., so we would still stand behind that argument.”