Equity market view: bullish or bearish as we head into year end?

The US is still on its Thanksgiving holiday, and as we wait to see if consumers around the world are confident enough to splash the cash during this time of high inflation, it is worth taking a broader view of the economic landscape. Unless there is a catastrophic fall for stocks in the first half of next week, then we are set to experience the first back-to-back month of gains for the S&P 500 since 2021. However, it is worth noting that the commentary has shifted. The narrative of peak inflation, Fed pivots and China re-opening has switched to concerns about a prolonged period of high interest rates in the US and China looking far from ending its zero covid strategy.

Below, we list four themes that we think could impact market sentiment and may cause markets to change direction.

The Fed’s phantom pivot

1, The market has acted like the Fed pivot was all but-certain when US CPI came in lower than expected early in November. When the inflation print came out on 10th November, the S&P 500 surged more than 5%. Since its low point, the S&P 500 is up more than 13%. This euphoric reaction to lower inflation may be short-lived, especially if it is reliant on a Fed pivot when it comes to interest rates. One definition of pivot is to swing, swerve, deviate or turn, which suggest that the Fed will continue to hike rates and the rapidly start to cut them. However, the mood may be shifting. According to CME Fed watch, the market expects rates to rise by 50 basis points in December, another 50 bps in February and to peak at 5-5.25% in March. The Fed is only expected to start cutting rates at the end of last year, with a 28% chance of a 50-basis point cut in December 23 to 4.5-4.75%. This means that over the coming months, the US economy will have to traverse over a land of high interest rates. Also, if core prices, which didn’t fall by as much as headline inflation last month, stay stubbornly high then interest rates may need to stay elevated for a longer period. This is not good news for stocks, especially as they have other factors to worry about that could drive stocks lower.

2, The China opening trade:

This looks like it has hit the skids already. Several lockdowns have already been enforced, there have been protests at iPhone factory as workers get tired of continuous lockdowns and quarantine camps are once more being built in Guangzhou. There is now a record number of new Covid cases in China, and cities including Beijing are suffering severe outbreaks. This is significant, Beijing is where the China’s leaders are based, if cases are rising there then you can assume that zero covid plans will be shelved for the time being. Whether or not China does end zero covid, it seems unlikely that they will do this winter, with springtime 2023 now more likely. However, with several false dawns that Covid zero would end, will investors be confident enough to put this trade on? Until China does end its policy of lockdowns, this could hit German stocks who were expected to be beneficiaries of China’s reopening trade. If China stays locked down then it could limit inflation, however, at some stage China will re-open and when that happens, we expect inflation to surge, thus the inflationary impact from the China reopening trade has been postponed, not eliminated.

3, Earnings data:

Companies are now expected to report a year over year decline in earnings in Q4 2022. The blended earnings growth rate for the US index in 2022 is expected to be -1%, after a surge in the number of analysts revising down their expectations. Since the end of September, earnings expectations for the S&P 500 have fallen by nearly 5%, led by materials, communication services and consumer discretionary, according to FactSet. If the S&P 500 does report a YoY decline in earnings in Q4, it will be the first time that it has done so since Q3 2020. The slip up in earnings is not expected to persist, it is worth noting that analysts expect earnings growth for the S&P 500 to rise by 2.3% in Q1, and to report positive earnings growth in all four quarters of 2023. The cup half full mentality says that one needs to be wary as they can change as the situation changes, however, the optimist would rejoice at the fact that earnings should bounce back, so maybe this is a reason to buy stocks now?

4, Sterling outlook

GBP/USD may be down on Friday; however, it is back above $1.20, a key psychological milestone and more than 1700 pips above where it was at the end of September. The mood music seems to have shifted for sterling, and we have been a cheerleader, we have spoken about the reduced economic policy uncertainty premium that has weighed on sterling since the Brexit vote now that Rishi Sunak and Jeremey Hunt are in charge. The change at number 10 has been welcomed by the FX market, along with their attempts to develop closer ties with the Eurozone, our largest trading partner. However, reality is now starting to bite. The OECD has predicted that the UK will have the worst growth performance of any G20 country bar Russia next year, the UK has suffered a bigger shock to its terms of trade because of Brexit, the pandemic and deglobalisation, which has pushed up inflation. This is expected to make it harder for the BOE, compared to other central banks, to control inflation. This is leading some to expect that the UK will need to experience a major recession to tame inflation, something that hedge fund Rokos has warned about. They believe that the impact on sterling and on the economy will have “serious societal implications” and could threaten jobs as well as the sustainability of public services. One way for the UK to escape this gloomy future, according to Rokos, would be to “quietly engineer a softer Brexit”, or have higher immigration. Right now, the Tories seem to have a better record at achieving the latter, although we believe that the former will need to happen at some stage, even if it upsets the Brexiteers. Another way for the UK to avoid the fate that Rokos predicts is to overhaul the mortgage market. One of the concerns about the UK economic outlook is that interest rates will need to stay higher for longer to tame inflation. This is a problem since the UK has relatively short mortgage rates, which expire more quickly than in other countries, this means that more UK householders will need to re-mortgage at higher rates next year than other countries, which threatens consumption and could threaten the value of the pound in the year to come.

Overall, when you trade financial markets, its worth taking off the rose-tinted glasses to see if the themes you are trading on play out in real life. There are signs that some of these assumptions won’t happen, which could hurt your portfolio.