Global Growth Fears Have Now Taken Control Of The Market

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Reality is setting in for the equity market as the fall rally ends. While the knee-jerk reaction from the equity market was that nothing new from Jay Powell was dovish, reality draws closer with the next FOMC meeting just a week away. One likely to see the Fed raise rates by at least 50 bps and signal further tightening in 2023.

The other reality is that the US economy is probably heading to either a recession or a long period of stagflation. The Bloomberg Recession probability forecast is now at 62.5%, a high enough reading to worry markets.

Recession Odds

Bloomberg

Higher For Longer

This worry is evident when the dollar, rates, oil, and stocks fall. Additionally, the bond market is telling us that the Fed will keep rates high for a very long time and that rising unemployment may not even prompt the Fed to cut. The 10-year minus 2-year spread is around -80 bps, the lowest level since 1981. The steepness of the yield curve is a reflection more so of when the bond market anticipates the Fed cutting rates. The steeper the curve, the longer the bond markets’ view of when the Fed will cut rates.

Yield Curve Inversion

Bloomberg

Typically the yield curve begins to rise in anticipation of the unemployment rate rising. The rising unemployment rate is a precursor to a recession, generally when the Fed starts to cut rates. It isn’t so much that the yield curve inversion is predicting a recession. The yield curve is predicting a rising unemployment rate. The recent labor report points to the labor market’s strength, which is why the yield curve inversion continues to deepen. The bond market is saying that the Fed will have to hold rates high for a long time to raise the unemployment rate over the next two years. However, the long end of the yield curve implies that keeping rates high for a prolonged period will negatively impact growth.

Oil Is Breaking Down

On top of that, oil prices have broken below some key technical trend lines, a global growth signal. Oil should be performing well given that the US will need to refill its oil reserve, prospects of a China re-opening, further oil production cuts, Russian sanctions, and a declining dollar. Instead, oil prices have collapsed, a sign of weakening demand and fears of slowing global growth. The more oil prices fall, the more likely the global economy is entering a period of weak growth. Oil has fallen below a critical uptrend line, and should it stay below that trend line; it signals a potential decline to around $66.

Oil

TradingView

Risk-Off Taking Hold

It’s resulting in a changing sentiment in the market where falling rates, the dollar, and oil shift from signs of inflation cooling and easing financial conditions to classic risk-off growth concern signals. The kind that leads to earnings estimates for the S&P 500 falling and multiples contracting.

The entire rally off the October lows has been driven by multiple expansion, as the S&P 500 with the 2023 PE ratio rising to 17.1 from 14.4. During a period of slowing economic growth and margin compression, PE multiples should contract as earnings estimates fall, so the current ratio is too high. We also have seen earnings estimates fall by around 6% for 2023 from a high of roughly $250 to its approximate $235.

S&P 500 earnings

Bloomberg

How far earnings estimates fall will depend entirely on the type of economic environment that comes next. If it’s a stagflationary slow growth high prices time, earnings could hold up quite well. If it’s a recessionary period, earnings will likely deteriorate further and fall below the 2022 levels of approximately $220 per share.

It potentially creates a wide band for the S&P 500 to find fair value. In a recession, a 14 PE times $220 earnings estimates value the S&P 500 at most at 3,080, while in a stagflation world where earnings remain around $235 per share, 14 times earnings values the S&P 500 at 3,290. In either case, it places the S&P 500 at significantly lower levels than its current level of approximately 3,950.

If the bond market’s assessment of high rates for a very long time is correct, then we should continue to see further weakness in risk assets as the market shifts into a classic risk-off mode heading into 2023. Lower rates, a weaker dollar, and falling oil prices will no longer be seen as easing financial conditions helping to lift stocks. No, these will be the classic growth warning signs, and during periods like that, multiples contract and stock prices struggle.

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