Aafter a nightmare In 2022, shocked investors will have to compensate for losses and ponder a lot. There are asset class allocations to be made, industries to be favored or avoided, and every economic variable under the sun to be forecast. Professional money managers have the added headache of figuring out how to stop nervous clients rushing for the exits. But one question dominates the rest, and it’s the impossible that looms over every crash. Is the worst over?
Economically, there is a clear answer: this year will be bleak. Kristalina Georgieva, head of the IMF, warned on January 1 that a third of the global economy is likely to slip into recession in 2023. In the eurozone and the UK, the downturns have probably already started. In a recent survey of economists from the University of Chicago and the financial times85% thought America would follow before the year was out.
This doesn’t guarantee another bloodbath – it could even mean the opposite. In theory, markets are forward looking and recession fears dogged the world for much of 2022. Such widespread consensus should feed into today’s prices, meaning that even a marginally better outlook would boost prices. In fact, analysts at JPMorgan Asset Management are using the strength of the consensus that there will be a recession to argue that stock prices will indeed end 2023 higher than when they started. You are not alone in your optimism. Goldman Sachs researchers expect stock prices to fall in the short term but recover by the end of the year. Deutsche Bank’s bullish pilot bill s&p 500 index of large American companies to end the year 17% higher than it is now.
If this year offers a repeat of 2022, with heavy losses for both stocks and bonds, it will be an unusual one. Stock prices usually go up. They rarely turn down two years in a row. That s&p 500 last did so two decades ago, when the dot-com bubble burst. Last year’s bond crisis came as the US Federal Reserve raised interest rates at the fastest pace since the 1980s, which is unlikely to be repeated.
Despite this, there are reasons to believe that more pain is to come. First, stocks remain expensive relative to their underlying earnings by historical standards. Despite last year’s slump, price-to-earnings multiples for “growth” stocks — stocks of companies that promise big future earnings — have only fallen to where they were in 2019. This was the highest level since the 2007-09 global financial crisis, a level reached after a decade-long bull market. That’s right, “value” stocks, those with a low price relative to the company’s book value, look more attractive. But when the recession hits, both species are vulnerable to earnings downgrades, most of which haven’t happened yet.
Moreover, today’s valuations were reached at an unusual time: a time when central banks endlessly pumped liquidity into the market through quantitative easing (qe). By buying government bonds with newly created money, the Fed and others pushed down yields, prompting investors to seek yield in riskier assets like stocks. Now this one qe Programs are run backwards. One consequence is that governments will rely much more on private investors to hold their debt. In fiscal 2022-23, the US Treasury Department may need to borrow from investors almost twice as much as in each of the two years prior to the Covid-19 pandemic and four times as much as in the five years prior. Even if central banks don’t hike short-term interest rates, this tide could push bond prices down and yields up. Just like in 2022, equities would therefore appear less attractive in comparison.
The final reason for the gloomy sentiment is a divergence between economists and investors. Although Wolks are betting on a recession, many punters are still hoping that a recession can be avoided. Markets expect the Fed’s interest rate to peak below 5% in the first half of this year before declining. Central bank governors disagree. They expect the interest rate to end the year above 5%.
As a result, investors are either betting that inflation will come down to target faster than the Fed expects, or that policymakers won’t have the heart to inflict the pain it would take to bring it down. Of course, there’s a chance they’re right. But markets spent much of 2022 underestimating the Fed’s dovish stance, only to be bullied by Fed Governor Jerome Powell at meeting after meeting. If the pattern repeats itself, 2023 will be another miserable year for investors. ■
Read more from Buttonwood, our financial markets columnist:
India’s stock markets are booming. They also have serious flaws (Dec 20)
For bond investors today, every country is an emerging market (December 8)
Has Private Equity Avoided the Crash in Asset Prices? (December 1)
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