S&P 500 gains are another potential ‘shock’ awaiting financial markets trying to shake fears of stagflation: economist

Target on Wednesday reported a 52% drop in first-quarter earnings, missing Wall Street forecasts and sparking a broad market sell-off.

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Worse-than-expected earnings reports from the largest publicly traded US companies are likely to provide another “shock” for investors struggling to overcome fears of stagflation.

That’s the view of Thomas Mathews of Capital Economics, who says that with more bad earnings news, the S&P 500 index can easily bottom out at 3,750 and likely lower. On Thursday, the S&P 500 SPX closed -0.58%, down 0.6% at 3,900.79, a day after posting its biggest one-day decline since June 11, 2020. It failed to break below the 3837.25 level which would have marked the technical definition of a bear market according to Dow Jones Market Data.

Read: Despite the recovery, the S&P 500 is hovering close to the bear market. Here the number counts

Wednesday’s brutal stock sell-off seemed to mark a reversal in markets as cracks in earnings results at big-name retailer Target Corp. TGT emerged, -5.06% after a profit slip from Walmart Inc. WMT, -2.74% on the previous day – a sign that higher inflation is seeping into almost every corner of the US economy. Over the past year, investors, traders and professional forecasters have remained optimistic that inflation will eventually ease. Markets have yet to price in a worst-case scenario for the economy in which inflation fails to ease and/or the US slips into recession, analysts said.

“The broader economy is being hit by this robust inflation that we’re seeing, and I don’t see any resolution until stock prices start reflecting lower GDP and earnings growth,” said Tom di Galoma, Treasury trader at Seaport Global Holdings in Greenwich, Connecticut.

Although the S&P 500 is poised to enter a bear market, earnings expectations remain positive, Capital Economics’ Mathews wrote in a note Thursday. Analysts, on average, expected companies in the index to post near double-digit earnings growth over the next several years, he said. And forward 12-month earnings expectations for S&P 500 companies remain around 16% higher than their pre-pandemic trend, according to the market economist.

Source: Refinitiv, Capital Economics

After the index fell 4% in a single day on Wednesday, “the gains are definitely a shock to the S&P 500,” Mathews wrote in an email to MarketWatch. “And earnings expectations still seem very optimistic, suggesting there’s a lot more potential on this front.”

More bad earnings news could push the S&P 500 as high as 3,750 points, but even that might be overly optimistic, he said. In the event of a recession, “it wouldn’t be out of the question” for the index to fall 20% from here based on historical experience.

Refinitiv’s S&P 500 Earnings Scorecard, released last Friday, shows that there have been 55 negative second-quarter earnings per share announcements from S&P 500 companies. 28 have a positive attitude towards this.

Below is an overview of the risks faced by the markets:

inflation

Inflation tops the list of shocks currently permeating the financial system.

A key reason is that the US — which posted an annual compound rate of 8.3% in April’s CPI report, still near a 40-year high — may not be past the peak of gains just yet. Disruptions from China’s zero-tolerance policy on COVID-19 and Russia’s war on Ukraine have yet to be fully reflected in the data, and traders expect five more months of readings above 8%.

Read: The next big shoe to fall in financial markets: inflation, which does not respond to Fed rate hikes

“Growth Anxiety”

Wednesday’s brutal sell-off in stocks — which sent the Dow industrials down 1,164.52 points and sent the Dow, like the S&P 500, through its worst daily decline in nearly two years — tasted markedly different from previous sell-offs.

The recent decline “had all the hallmarks of a growth scare,” Mathews wrote in his note. Bonds rallied as investors unwound bets on rate hikes, safe-haven currencies strengthened and stocks sold off across the board.

By comparison, the factors behind most of the declines in stock prices this year have largely been linked to rising “safe” returns on assets as investors embraced the Fed’s hawkish stance, he said.

As of this week, stock markets in the US and euro area appeared to be pricing in a roughly 70% chance of a short-term recession, based on an estimate by Marko Kolanovic of JPMorgan Chase & Co. et al. From their point of view, this is “too much recession risk”.

However, one underestimated risk is how quickly financial and economic conditions could deteriorate in the current environment. Seaport’s di Galoma expects the U.S. to fall into recession by early 2023, though arrival time is “accelerating and will come a lot quicker than people think.” “It’s right on our doorstep and I think this recession is going to be pretty deep,” di Galoma said by phone Thursday.

Higher interest rates

The Federal Reserve remains poised to further tighten financial conditions, with a reduction in its nearly $9 trillion balance sheet starting next month and policymakers set to make two more 50 basis point rate hikes in June and July. Monetary policy alone is another “key shock,” albeit one that has lasted for a while and is weighing on earnings multiples, Capital Economics’ Mathews said.

Investors have even tried to overlook the impact of rising interest rates, for example on May 4 when Fed Chair Jerome Powell told reporters that a 75 basis point rate hike was not actively being considered. Stock market investors cheered the remark but lost enthusiasm the very next day – with the Dow Jones Industrial Average DJIA down more than 1,000 points, -0.75% on May 5th.

Russia, Ukraine and China

Russia’s war against Ukraine, which is still raging after almost three months, “still has the potential to cause significant volatility in commodity prices, affecting the outlook for both earnings and monetary policy (by stimulating or cooling inflation) could affect it,” Mathews said.

Additionally, China’s COVID-19 lockdowns are affecting the entire world, dampening global growth prospects and exacerbating inflationary pressures due to the Asian country’s role as a manufacturing powerhouse and source of many of the world’s goods.

“A confluence of events (inflation and the impact of policy responses to it, the war, China’s zero-COVID policy and broader supply concerns) may cause volatility to persist in the near term as we gain more information on each other’s progress.” Andrew Patterson , a senior international economist at The Vanguard Group, said in an email to MarketWatch.

cryptocurrency

Stablecoin TerraUSD’s crash last week has raised concerns in some corners of the market that stablecoins could be overall destabilizing and triggering systemic risk.

That is the case, although Treasury Secretary Janet Yellen has tried to dispel the notion of a threat to financial stability while still acknowledging the risks. Regulators are concerned, and at least market participants might be wondering whether more idiosyncratic runs on stablecoins are on the horizon, whether there are any risks of contagion, and what the implications might be for broader money markets.