Markets face a tough summer

Stocks face a difficult few months

Central banks around the world are raising rates, growth is slowing, and prices are continuing to rise at their strongest pace in decades. Taken together, these problems mean that equity markets face their most gloomy outlook since the Covid-19 pandemic.

In the long-run, earnings and expectations of future earnings, drive stock markets. When earnings forecasts begin to fall, stock prices tend to come down with them. This is what has played out over the past six months in global equity markets – rising inflation and higher interest rates mean that consumers have less money to spend. This then suggests earnings will fall, resulting in a drop for stock prices and valuations.

It does not appear as if this situation is about to change in the near future. The Federal Reserve (Fed) has downgraded its growth forecasts for the coming quarters, and many investors expect even these lowered expectations to be missed, and a recession to occur.

Investors remain pessimistic

The weakness in stock markets over the past half-year has come as a sharp contrast to the post-Covid-19 pandemic bounce. Loose monetary policy and plentiful quantitative easing, plus a rebounding global economy, meant that there was a strong case for stocks to rebound. In this situation, investors were happy to keep putting money to work in equities.

But now much of that flow has dried up. The recent fund manager survey from Bank of America (BoA) showed that pessimism is widespread on both the economy and stocks. Investors expect earnings to weaken and growth to keep slowing, and on current evidence they may well be right.

This scenario is unlikely to end in the kind of ‘v-bottom’ that we saw at the end of 2018 and in March 2020. Inflation is strong and central banks are raising them and intend to go on raising them for the foreseeable future.

Is the bear market finally here?

It is true that the great post-2009 bull market has included a number of big selloffs, not least of course March 2020 that arguably reset the bull market and began a new one. Indeed, history shows that 20% corrections in stocks are a regular occurrence, rather than a rare event.

But the bearish case is now the strongest it has been for over a decade. Central banks are tightening policy not just because they want to move away from ultra-low, ‘emergency’ policy that has prevailed for much of the past ten years and more, but because they are having to scramble to bring inflation back under control.

There is still a chance of a market rebound over the summer – sustained bear markets often see dramatic and drawn-out rallies, but with such a tough outlook for the global economy and for earnings, the broader environment for stocks looks quite gloomy. Ultimately, the market will recover, but it will take a sustained drop in inflation, a revival of earnings forecasts and perhaps even a return to rate cuts by central banks for a more bullish view to emerge in the long term.