In recent weeks there has been a partial reversal of these trends as softer US inflation data prompted hopes of a Fed policy pivot, strong retail sales data pointed to US consumer resilience, and investors unwound extreme positioning.
The S&P 500 has rallied 10% from its October low, 10-year Treasury yields are 42bps below their peak, and the USD has depreciated by 5.7% since its September high.
But we see reasons to suggest this reversal trade is not the start of a new market regime:
First, it’s too early to expect a Fed pivot. Fed officials have pushed back against hopes for a pause in rate hikes to try to prevent financial conditions from easing too much. If Chair Jerome Powell reiterates this in the next two weeks, this would be an even stronger headwind for the reversal trades. For now, we can be pretty confident that the Fed will continue to hike rates into 1Q23 and growth will continue to slow, a combination that’s not good for risk assets.
Second, the market tailwind from hedge fund and systematic investor re-risking over the past month is fading now that positioning is less extreme. Also, the net bullish sentiment shown by the American Association of Individual Investors’ survey has moved up to –7 from –43 two months ago. When sentiment reached similar levels on three occasions earlier in the year, the S&P 500 subsequently experienced selloffs with an average decline of 16%.
Third, valuations don’t support significant market upside. The S&P 500 forward P/E has risen to slightly above 17x. Historically, when the P/E has been more than 18x, expected earnings growth averages 14%. Currently, bottom-up consensus expects much lower growth (5% over the next year), and we believe earnings will fall 4% next year. In other words, we think it’s hard to justify much—if any—valuation expansion right now.
The medium-term market outlook ultimately hinges on how much and how quickly inflation and economic growth fall, and how Fed policy reacts to the evolving macroeconomic landscape. That’s why we expect 2023 to be “A Year of Inflections.” But, for now, with inflation still high, interest rates rising, and economic growth falling, we favor defensives and value, income opportunities, safe-haven currencies, and diversification with alternatives.
Read more in our latest blogs: Race to the bottom and Sentiment at levels that preceded recent market sell-offs (both published 21 November 2022).
Main contributors - Mark Haefele, Jason Draho, David Lefkowitz, Vincent Heaney, Jon Gordon
Content is a product of the Chief Investment Office (CIO).
Original report - Reversal in risk appetite may not prove durable, 22 November 2022.
