It's been a hard year for markets, and investors are looking for a bit of reprieve as we enter the fourth quarter — historically a good one for stocks, especially during midterm election years. Unfortunately, this year may buck the trend.
The outlook, as Goldman Sachs analysts put it, is "murky," and more volatility is expected. With so much uncertainty around inflation, central bank policy, and corporate earnings, investors could be in for a tumultuous end to a tumultuous year.
What's happening: Investors waded through a very bad third quarter — they grappled with persistent inflation and aggressive interest rate hikes by Western central banks, repeated lockdowns in China, and an energy crisis in Europe.
The S&P 500 fell 1.5% Friday and was down nearly 24% so far this year. All three major indexes are in a bear market — or down at least 20% from recent highs — and economists are warning that the stage is set for a global recession.
Here's what to watch out for in Q4.
Central bank problems: Some investors are hoping that monetary policymakers turn more dovish this quarter, pivoting away from aggressive rate hikes. But inflation has been persistent.
The Federal Reserve's preferred benchmark for consumer inflation, the Personal Consumption Expenditures price index, rose in August from the previous month. That puts more pressure on the central bank to continue its aggressive rate tightening policy.
Investors still underestimate the central bank's resolve to raise interest rates, wrote Lisa Shalett, chief investment officer of wealth management at Morgan Stanley, in a note. That means markets are more susceptible to steep drops when hikes happen.
The higher rates go and the longer central banks keep them there, the narrower the chance of avoiding recession becomes. The pain is already beginning. Soaring mortgage rates, nearing 7%, have helped push down existing home sales for seven months in a row.
The Fed meets again in early November, and as of Friday, investors were putting the probability of another three-quarter percentage point hike at nearly 60%, according to the CME FedWatch tool.
Earnings weakness: Third-quarter corporate earnings begin soon, and the outlook is gloomy.
According to FactSet, companies in the S&P 500 are expected to report their lowest year-over-year earnings growth since 2020.
Analysts are signaling pessimism. They've lowered their earnings growth outlook to 3.2%, down from 9.8% since June.
"Weakening earnings will be a challenge to markets," wrote BNY Mellon analysts. The S&P 500's price-to-earnings ratio, the relationship between a company's stock price and earnings per share, is still near historic highs. That means if earnings weaken, sell-offs and market drops are likely.
The impact of central bank policy on the economy and corporate profits tends to come with long lags, said Morgan Stanley's Lisa Shalett. So even if corporate earnings beat estimates, pain could lie ahead.
"This means investors could be getting a false sense of security from whatever earnings potential they see in stocks today," she said.
The bright side: Analysts at Barclays say that there will be some pain, but it won't be unbearable. "Our analysts are still bearish on most risk assets, but they feel as if much of the adjustment has already occurred," they wrote. "We see more gloom than doom."
History is on the side of investors, after all. Since 1928, the S&P 500 has gone up 73% of the time in the fourth quarter, with an average gain of 7%, according to Howard Silverblatt at S&P Global Indices.
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