The year kicks off with inevitable market predictions, ranging from the sublime to the ridiculous. While some promise eye-watering rallies, others warn of impending disaster. Out of left field, we even have the wisdom of Dmitri Medvedev, the former Russian president and freshly-minted market strategist, who foresees the collapse of the Bretton Woods system and the relocation of all major stock exchanges to Asia. (Also, yes, a new German empire, a U.S. civil war and Elon Musk as president of a new breakaway confederacy!).
Most mainstream forecasts and what appears to be consensus, look much blander. Investors seem to believe the U.S. Federal Reserve will continue to hike rates through summer and then cut rapidly as inflation cools and the economy weakens. Treasury yields that grind lower suggest a recession, while stocks that bounce signal the downturn may not be so bad. Returns won’t be great, but they won’t repeat the disasters of 2022.
Ho hum. Average guesses for the S&P 500 by December coalesce above 4,000, or little higher from this week’s levels. It all sounds plausible, but it also sounds like a lot of shell-shocked investors don't really want to stick their necks out too far.
The careful investor, however, will be looking hard at the space in between consensus and Cassandra. Where could the conventional wisdom reasonably go wrong, without outlandish speculation? What are the most likely “pain trades” that will catch the market flat-footed?
At the top of the list is a much more serious recession. Currently, the median forecast compiled by Bloomberg has U.S. growth falling from roughly 2% last year to 0.3%, rebounding to 1.3% in 2024. Interestingly, the Fed’s own forecasts are higher at 0.5% and 1.6%, suggesting the economy can withstand tighter policy for longer.
But we all know that monetary policy operates with a lag, meaning the full impact of last year’s sharp hikes is yet to come. We also know that the strong labor markets and corporate profits that give us comfort are also lagging, meaning they can evaporate faster than you can say “pivot.”
Most worrying, business models built on two decades of cheap money now face the grueling test of operating amid higher and more volatile rates. Even if headline inflation edges lower, there are sure to be victims of this tightening cycle beyond the isolated turmoil we have seen from U.K. pension markets and Bahamian crypto desks.
As U.S. households whittle down their savings and corporations face steeper refinancing risks, the mild recession everyone has penciled in could turn much more painful. Bonds may stabilize as the Fed cuts rates, but this would deliver another awful year for equities.
A second, and even more damaging, scenario could come from inflationary pressures that don’t dissipate much at all. Market forecasts have Core Personal Consumption Expenditures (PCE) Price Index, the Fed’s preferred measure, falling from 5% last year to 3.6% on average this year and 2.4% in 2024. The Fed’s estimates are not much different.
But it doesn’t take much to paint a picture that includes a fresh surge in inflation or at least a much slower and more volatile decline. Supply chains appear to be normalizing as the costs of shipping a container from Shanghai fall to pre-pandemic levels. But the chaotic re-opening in China threatens to disrupt production and trigger fresh shortages in the near term.
Alternatively, if the government doesn’t flinch at the rising infection rates, a Chinese economy entirely freed from COVID restrictions will drive global energy and commodities prices higher. A colder turn in Europe’s weather could accelerate the trend. And among the biggest uncertainties of all, the U.S. labor market could easily run tight for much longer with 5% hourly earnings growth persisting in spite of the Fed’s recent efforts.
There’s already a disconnect between the Fed’s dot plots and investor expectations. The market assumes that the inflation story is over, with rate cuts in June to support flagging demand. The projections from the members of the Federal Open Markets committee show remarkable consensus around rates that hold firm above 5%, at least into 2024. This suggests a further unexpected surge of “stagflation,” with more painful losses for both stocks and bonds.
Perhaps the least painful of the pain trades involves the defeat of inflation with even more resilient growth. A more decisive fall in energy and housing costs would boost consumer optimism and corporate margins even without Fed action. Wages stabilize as the workforce expands, banks start lending again and growth accelerates. It’s not wildly impossible, even if it’s not anyone’s central scenario.
Still fewer investors anticipate even darker alternatives. Social unrest in Russia amid a lagging war effort could cut its oil and food exports even further, delivering unexpected inflationary shocks to the world’s emerging markets. Chinese COVID infections could spread in new variants to other parts of Asia. Japan’s steps to weaken yield curve control risks sending financial shock waves from one of the last great sources of cheap money.
It’s easy to spin even more extreme versions of doom (and recovery), but it quickly becomes impossible to assign probabilities to outcomes that are conceivable but only barely possible.
So bland consensus may be the best place to start, since the preponderance of evidence points toward mild recession and rangebound markets. But it’s also important to watch for where conventional wisdom will be surprised one way or another. Stabilizing U.S. wages would be a very good sign; collapsing house prices would signal much worse.
Classical scholars will remind us that Cassandra’s dire prophecies were true in the end, even if no one believed her. But investors know that markets reflect above all what everyone believes. Successful portfolios focus on the consensus, but brace for where it may move next
Christopher Smart is chief global strategist and head of the Barings Investment Institute.