What happened?

The S&P 500 fell 2.1% on Wednesday, giving back some gains after a three-day rally that had lifted the index by 2.8%. Control of Congress hung in the balance following Tuesday’s US midterm elections. So far, the results have shown only modest gains for the Republican Party, while the Democrats have fared better than expected.

All S&P 500 sectors came under pressure in a broad risk-off move. Energy, IT, and consumer discretionary led the declines. Defensive sectors like healthcare and utilities declined the least.

Weaker oil prices weighed on energy stocks. Brent crude oil prices fell 3% to USD 92.6 per barrel, extending their losses this week to 6% amid a rise in US crude inventories and concerns that rising COVID-19 cases in China could affect oil demand.

Treasury yields dipped. The 10-year yield fell 3 basis points to 4.1%, while the 2-year yield fell 3 basis points to 4.64%. The DXY dollar index advanced 0.8%.

The price of Bitcoin dropped 15% to USD 16,000 following a liquidity crunch at crypto exchange FTX. Facing insolvency rumors and a surge in user withdrawals, the exchange had agreed to a rescue sale of its non-US assets to rival Binance, which on Wednesday withdrew from the deal.

What do we expect?

Wednesday’s risk-off move in markets likely reflected a combination of factors. The US midterm results so far indicate that the expected “red wave”—a decisive Republican victory—has not occurred. Instead, investors face a period of uncertainty. At the time of writing, Republicans are likely to take control of the House of Representatives by a modest majority, but control of the Senate remains on a knife-edge. The Senate race in Georgia will not be decided until a runoff election on 6 December.

Since 1982, the S&P 500 has moved higher in the 12 months following the midterms on all 10 occasions, with an average rally of around 13.5%. Of course, this year could break this trend, given the various headwinds facing markets, including stubbornly high inflation, aggressive central bank rate rises, and heightened geopolitical tensions.

Inflation concerns may have contributed to Wednesday’s sell-off, as some investors sought to reduce risk ahead of the key US consumer price index release on Thursday. While investors are hoping for a slowdown in inflation, we note that the Cleveland Fed’s NOWcast is pointing to a headline rate of 0.8% month-over-month in October—too high to offer much reassurance to the Federal Reserve.

Steep falls in cryptos may have undermined sentiment toward more speculative assets as financial conditions continue to tighten. Aside from a spike during the start of the pandemic, the Chicago Fed’s National Financial Conditions Index is at its tightest since the global financial crisis.

The impact of monetary tightening is also showing up in lending behavior. November’s Fed quarterly Senior Loan Officer Opinion Survey released this week showed that 39% of banks are tightening lending standards for commercial and industrial loans. While banks no longer provide the majority of lending, trends in lending standards have historically been a leading indicator for corporate profits. The current tightening trend has accelerated sharply over the last year and suggests further downward pressure on S&P 500 profits in the quarters ahead.

Overall, we do not believe the conditions are in place for a sustained equity market rally. The Fed, along with other major central banks, looks likely to keep tightening rates until the first quarter of 2023; economic growth will likely continue to slow into the start of the new year; and global financial markets are vulnerable to stress while monetary policy continues to tighten. In addition, we believe such headwinds have yet to be fully reflected in earnings estimates or equity valuations. We expect global earnings per share to fall by 3% in 2023, versus the bottom-up consensus for 5% growth.

How do we invest?

The risk-reward for markets over the next three to six months looks unfavorable, in our view. However, given the potential for periodic bounces, we advocate strategies that add downside protection while retaining upside exposure.

Against the current backdrop, we recommend focusing on defensive assets when adding exposure. Within equities, we like capital protection strategies, value stocks, and quality income. We prefer global healthcare, consumer staples, and energy, and have a least preferred stance on growth, industrials, and technology. By region, we like the cheaper and more value-oriented UK and Australian markets relative to US equities, which have a higher technology and growth exposure and where valuations are higher.

Within fixed income, we prefer high-quality and investment grade bonds relative to US high yield. In currencies, we prefer the safe-haven US dollar and Swiss franc relative to the British pound and euro. We also recommend seeking uncorrelated returns in hedge funds, for example via macro strategies, which have outperformed year-to-date.

Regarding cryptos, as we have long warned, trading in coins and tokens can result in the complete loss of one’s investment. Investors interested in long-term exposure to the theme can consider crypto-related opportunities, like more traditional platforms and enablers that can adopt blockchain technology into existing businesses.