Global Stocks Rally: Is it Sustainable or a Bubble About to Burst?

Global stock markets have risen on optimism that central banks will soon begin to curb their aggressive interest rate hikes as inflation shows signs of peaking, but strategists are skeptical that the rally will last.

Last week, markets were lifted after U.S. inflation fell short of expectations in October, prompting investors to bet that Federal Reserve policymakers would soon have to reduce or stop the monetary policy tightening tools they have used to try to bring prices down. The S&P 500 gained the most in a single day since the early 2020 pandemic rebound rally.

Fed Governor Chris Waller, on the other hand, warned on Monday that global markets had overstated the impact of a single data point and that the US central bank still has “a ways to go” on interest rate hikes.

Several analysts have recently reiterated that stance. According to a note issued by BlackRock Investment Institute on Monday, labor limitations driving wage growth and core inflation may be more durable than the market is pricing.

Though rising stock prices indicate that markets are reinforcing their hopes for a Fed soft landing, BlackRock’s top strategists disagree and remain underweight developed market stocks.

“Equities have frequently risen this year on hopes that the Fed is moving closer to ending the quickest hiking cycle since the 1980s, allowing the economy to experience a gentle landing that avoids recession,” said Jean Boivin, Head of the BlackRock Investment Institute.

“We believe such hopes will be shattered once more as the Fed continues to tighten policy.” With the S&P 500 up 13% from its October low, markets are even further from pricing in the impending recession — and earnings downgrades.”

Earnings downgrades are central to BlackRock’s predicted negative surprises. While the market anticipates earnings growth to decrease from 10% at the start of 2022 to just over 4% in 2023, the world’s largest investment manager expects zero growth, noting that third-quarter annual earnings growth would already be negative if not for the massive windfalls observed in the energy industry.

“We need to see stocks fall more, or more good news of falling inflation,” Boivin’s team stated.

Dan Avigad, partner and portfolio manager at Lansdowne Partners, told CNBC at the Sohn London Investment Conference on Wednesday that as central banks attempt to restrict demand in order to moderate inflation, corporate profit margins will have to contract from their current “quite excessive levels.”

“We’re still running approximately 20% above the long-term norm in terms of earnings,” Avigad said. “It seems quite plausible to me that earnings trajectories for the broader stock market are being underestimated by as much as 15-20%.”

A pessimistic viewpoint

According to Capital Economics, last Thursday’s Wall Street rise was the S&P 500’s 15th greatest single-day increase since the mid-1960s. Senior Markets Economist Thomas Mathews wrote in a note Monday that while there is a case for further gains if falling inflation leads to the end of monetary tightening, the economic research firm remains bearish on equities due to threats to the growth and earnings prospects.

Capital Economics anticipates a slight recession in the United States and contractions in several key developed nations, a macroeconomic outlook that Mathews believes has not been properly discounted in global equity markets based on consensus profit estimates.

“Admittedly, the valuation of the US stock market has now fallen a long way (as have valuations of stock markets elsewhere), but the experience of recent US recessions is that the price/estimated earnings ratio of the S&P 500 fell a bit further around the onset of the recession, even if it was already low due to previous rate hikes and despite falls in real safe asset yields,” Mathews said.

“All of this means that the present rally’s longevity is dependent on incoming statistics on economic growth and business profitability as much as it is on inflation.”

For the time being, Capital Economics sees profits failing the market and further dragging on stocks, estimating the S&P 500 would fall to a trough of 3,200 by the middle of 2023, roughly 20% below its present level, with other global equity markets falling by comparable proportions.

However, this is not universally held. Patrick Spencer, vice chairman of equities at Baird, told CNBC that he hadn’t seen anything in the statistics that indicated a U.S. recession was imminent, and that last week’s inflation data suggests the economy is in for a “soft landing.”

“Equities trade on earnings revisions and the preponderance of the conversation is that we’re expecting a deep recession in the United States, and it just isn’t there right now,” Spencer added.

“Its earnings revisions and earnings still seem okay, both in Europe, and given the value, even in the United Kingdom, and in the United States, so we would still support that argument.”

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