‘Tougher times for equities are not far ahead’: Capital Economics predicts S&P 500 drops another 5% by year-end

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John Gress/Reuters

  • Stock market selling triggered by rising bond yields has sparked fears of a deeper selloff in markets.
  • “Tougher times for equities are not far ahead,” argues Capital Economics’ John Higgins, though he does not see a massive correction at hand.
  • Higgins sees the S&P 500 closing out the year at 2,600, down from current readings around 2,750.

Capital Economics is taking the middle ground between panic and euphoria: a dull, moderated pessimism.

Looking at the recent selloff in stocks, driven by higher bond yields and the fear the unexpected inflation will lead to more Federal Reserve interest rate hikes than anticipated, they see the signs of further turbulence – but not an all-out meltdown

“Overall, we are not convinced that this is the start of a major correction in the stock market, as the fundamentals remain healthy for now: bear markets have typically occurred just before the onset of a US recession (although 1987 is actually an outlier in this regard),” economist John Higgins wrote in a research note to clients.

“But we think that tougher times for equities are not far ahead, as Fed tightening is likely to take a toll on the economy before long. We are therefore sticking to our end-2018 forecast of 2,600 for the S&P 500.”

The following chart shows how the rise in yields had correlated positively with stocks until very recently, when rates began to rise on an inflation-adjusted basis.

Capital Economics

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Capital Economics

No Powell ‘put’

The Fed’s own forecasts suggest the central bank will tighten monetary policy three times this year, but the market has begun to suspect that four increases, potentially even more, are possible if things pick up.

Given his forecast for a significant but not crisis-like decline in stocks, Higgins does not foresee the kind of market event that would require Federal Reserve intervention, of the kind that might test the new Fed Chair, Jerome Powell.

“Unless the slump becomes a rout, he is unlikely to intervene,” Higgins said.

“Indeed, there are a couple of key reasons to think that a Powell ‘put’ is not on the cards,” referring to the notion that Fed chairs have tended to step in when market meltdowns get too severe, in part because they threaten the economy.

The notion started under Alan Greenspan’s chairmanship after he reacted to the 1987 stock market crash by trying to calm the markets.

For Higgins, “only if the S&P 500 fell well below 2,000 would Powell have as good an excuse today as Greenspan did in 1987 to try to stabilize the markets.” The index currently stands at around 2,750, so for now, it’s not even a close call.