Capital Economics: The three reasons the stock rally is over and will give way to another sell-off

By Eleftherias Kourtalis

The strong correction with which stocks started this week is a sign of things to come, as the rally that markets have recorded since mid-June not only has no chance of continuing, but is expected to reverse, with recent gains erased and losses to increase by the end of the year. That’s the view of many international houses such as Goldman Sachs, Bank of America, JP Morgan and Morgan Stanley, who have warned in a barrage of reports over the past week about the risks surrounding the outlook for stocks – and this view is shared by and Capital Economics in its new report.

As he notes, the S&P 500 managed to erase more than half of its losses since the beginning of the year with the rally of the previous six weeks, but this recovery will not be sustained and the index will record another strong correction in the rest of the year. plunging to 3,600, about 13% lower than current levels. It is noted that Goldman Sachs predicts that, in the event of a recession, the S&P 500 index will fall to 3,150 points at the end of 2022, i.e. by almost 24% from current levels.

The recent rally had two parts, explains Capital Economics. From mid-June to early August, it was likely due to the dampening of Fed rate hike expectations and the consequent decline in long-term real yields. Since then, however, the index has continued to move higher, despite a renewed rise in real yields. This is likely a result of increased investor confidence in an economic “soft landing” in the US, which, in turn, appears to have reduced equity risk premia

The house sees three ways the stock rally could extend further, which are all being dismissed.

First, risk appetite could continue to improve. But it already looks pretty healthy, especially given the still-challenging economic landscape. After all, while credit spreads, for example, are still above last year’s troughs, they are well below the heights reached during most previous periods of growth concern, such as the mid-2010s.

And while Capital Economics does not expect a recession in the US (at least by the broadest definition), the risk is higher than usual, and it predicts a recession in the eurozone and the UK, while it expects growth to continue to slow and in China. In this context, it is difficult to see an improvement in risk appetite and a reduction in the equity risk premium, much less in the short term.

Second, real returns on “safe” assets could start to fall again. It would be surprising, however, if this happened before inflation was more clearly under control. Although the Fed has begun to acknowledge the dangers of too much monetary tightening in its most recently published minutes, after understating inflation the central bank still does not want economic conditions to loosen too much until price pressures subside further.

“So we doubt he’ll want real returns on safe assets to fall,” notes Capital Economics. So, he adds, if real yields start to fall more decisively, as they did in June and July, the Fed would try to keep financial conditions tight. To some extent this has already happened as yields fell earlier this summer, with several Fed officials subsequently reiterating their commitment to bring inflation under control through rapid rate hikes.

Third, expectations for corporate earnings could start to rise again. These expectations appear to have been revised downwards, however they are still very high, and imply that profitability remains well above its pre-COVID trend. Given this and the still bleak economic context, it is therefore difficult to see them being revised upwards in the near term.

“All of this suggests that the rally in the S&P 500 is running out of fuel and we suspect it will start to reverse as the positive factors described above are also reversed. Given the bleak economic backdrop and a still hawkish Fed, we expect risk appetite to decline, real yields to rise and expectations for corporate profitability to be further revised downward,” Capital Economics said.

That, she explains, supports her forecast that the S&P 500 will reach 3,600 by the end of 2022, down from June’s low of 3,660 before the rally began.

The bigger picture is that this year’s sell-off was largely due to tighter monetary policy, so a rapid return to previous highs, as seen in some other bear markets of the past, would require a complete reversal of that tightening. And this is unlikely, as Capital Economics points out. With real yields expected, in its view, to remain higher than they were in 2020/2021, and the economy disappointing, the recovery of the S&P 500 will be slow and painful, with a lot of pain, before reaching previous highs.