Stock bulls seeing recession off the table and waiting for the next leg of the rally are bracing for disappointment as the fallout from the Federal Reserve’s monetary tightening is “still ahead of us,” according to strategists at JPMorgan Chase & Co. .
It is too early for stock market investors to believe that the pain to the economy from tighter monetary policy is already behind us or well absorbed, as the impact of interest rate hikes typically ripples through the economy with a lag of between one and two years, wrote JPMorgan strategists led by Mislav Matejka in a Monday note.
“We have been looking for a rebound in stocks since the fourth quarter of last year, driven by stalling yields, the reopening of China and our view that natural gas prices will fall,” the strategists said. “While we believe Q1 may initially remain robust, we do not expect it to be fundamental confirmation for the next leg higher and see the rally slowing as we move through this quarter, with Q1 possibly marking the year’s high .”
US stocks have rallied from their lows in October to give a strong start to the year, with the tech-heavy Nasdaq Composite
COMP
led the way, as the first expectations of an interest rate cut later in the year gave the market a boost. S&P 500
SPX
jumped 12.2% from an October low and is still up 4.1% so far this year, according to Dow Jones Market Data.
However, a series of warmer-than-expected economic reports, including inflation and jobs data for January, as well as weak corporate earnings and rising government yields, have driven the market’s repricing of the interest rate outlook.
Fed funds futures traders priced in a 76% chance that the Fed will raise interest rates by another quarter of a percentage point to between 4.75% and 5% on March 22, and a 24% chance of a bigger half-point. move, according to the CME FedWatch tool. Traders have only recently arrived at the Fed’s expectation that the Fed Funds rate will peak just above 5%.
See: The financial markets are waking up to an external risk of almost 6% fed funds rate by July
US stock indexes finished sharply lower on Tuesday as investors returned from the long holiday weekend. S&P 500 and Dow Jones Industrial Average
DJIA
each fell by 2%. The Nasdaq Composite retreated by 2.5 percent. All three indexes suffered their worst day since mid-December, according to Dow Jones Market Data.
Read: Why is the stock market falling? Blame a “perfect storm” as interest rates rise, dollar gains
The strategists said they could indeed see a Fed pivot toward lower interest rates, but perhaps only in response to “a much more problematic macro setup than the market is currently looking forward to.”
“Historically, stocks typically don’t fall until the Fed is advanced on cuts, and we’ve never seen a low until the Fed has stopped walking,” strategists said.
See: Investors have pushed stocks into the dead zone, warns Morgan Stanley’s Mike Wilson
Here are other money signals that are sending warning signals about the economy, according to JPMogran strategists.
Yield curve
The yield curve remains deeply inverted.
An inverted yield curve occurs when the yield on long-term government bonds falls below the yield on short-term certificates. This is seen as one of the most reliable leading indicators of recession, typically with a lag of a year or more.
“Although many are now actively trying to explain away the signal, we note that we have never escaped a recession from this point, and never had a sustained rally before the curve would show a meaningful and prolonged steepening,” Matejka said.
Money supply
The money supply continues to move lower in both the US and Europe, according to JPMorgan strategists.
US M1, which includes the most liquid parts of the money supply and is or can be quickly converted into cash, has entered outright contraction territory on an annualized basis for the first time since 2006, the strategists noted. Eurozone M1 continues to decline rapidly.
Tighter bank lending standards
The bank’s lending standards have been tightened, with a sharp drop in demand for credit, the JPMorgan strategists said.
“So far, actual credit growth has been robust, but that may not be the case from here. Economic conditions are becoming more restrictive. The bank’s lending standards across all categories have tightened significantly,” Matejka wrote in the note.
See: ‘Not a time to buy’: S&P 500 exits ‘best era’ in decades for earnings growth amid ‘dried up’ liquidity
