Do you fear a hawkish Fed? Here’s what likely limits more downside in the stock market, according to JPMorgan’s Marko Kolanovic.

The stock market has been under pressure since the August inflation report came out surprisingly strong last week, but Marko Kolanovic, chief market analyst at JPMorgan Chase & Co. , doesn’t see this year’s decline getting ugly despite the Fed’s hawkishness. .

“While we recognize that tighter central bank pricing and the resulting increase in real yields are weighing on risk assets, we also believe that any downside from here will likely be limited,” Kolanovic said in a JPMorgan research note on Monday. “Strong earnings, lower investor sentiment and well-established long-term inflation expectations should mitigate any downside in risky assets from here.”

Investors were preparing to raise interest rates from the Federal Reserve on Wednesday, the day Central Bank President Jerome Powell will hold a news conference on his latest policy decision as he battles high inflation. The S&P 500 is already down about 18% so far this year on concerns about higher interest rates and the continued rise in the cost of living in the US.

JPMorgan’s Kolanovic has a more bullish view of the stock market than some other Wall Street investors and analysts, including warnings from Morgan Stanley that stocks Can take another leg down And it retested the 2022 low that the S&P 500 hit in June.

Read: ‘some Twisted logic about valuation multiples: Stock market investors seem complacent as interest rates rise, Morgan Stanley warns

Kolanovic acknowledges the weight of higher real yields and higher expectations of the Fed’s final interest rate in the market.

“The Fed’s pricing peak as evident from the Fed fund futures is making new highs at 4.5%,” or 50 basis points above the previous high in June, he said. “Real yields are making new highs,” Kolanovic said, with the 10-year Treasury real rate exceeding 1% at nearly 210 basis points above its level at the start of the year.

Real returns are adjusted for inflation.

In Kolanovic’s view, stronger-than-expected corporate earnings this year help mitigate the stock market’s downside.

“Better-than-expected earnings growth reminds investors that equities are a real asset class that offers protection against inflation and is therefore more attractive than nominal assets, such as the vast majority of fixed income,” he said. “Even if we exclude energy, the sector that clearly boosted index-level earnings, the decline in earnings has been fairly small so far.”

JPMorgan global markets strategy note, dated September. 19, 2022

While falling earnings could become more significant if the unemployment rate begins to “physically” rise and the US falls into a deep or prolonged recession, Kolanovic sees potential support in the stock market.

“Even in this opposite scenario, we believe the Fed will cut interest rates by more than the current 2023 rate, thereby supporting equity markets and delivering higher price-to-earnings multiples,” he wrote.

Kolanovic also cited the investor’s position as a mitigating factor on the downside, saying equity funds have lost more assets under management this year than they gained in 2021.

“In other words, retail investors are back to their end of 2020 levels in terms of their stock allocation,” he said. At the same time, he wrote, “the equity positions of institutional investors are also low,” as evidenced by “agents of stock futures positions” as well as “consistently low demand for hedging.”

As for long-term inflation expectations in the US, Kolanovic noted that it has fallen recently based on market metrics as well as University of Michigan survey.

He said, “Stability in long-term inflation expectations reduces fears of de-fixing US inflation expectations, making the Fed’s prudent direction easier going forward in the scenario where labor market indicators weaken enough to confirm a US recession.”

US stocks closed higher on Monday after a choppy trading session ahead of the two-day Federal Reserve monetary policy meeting, with the Dow Jones Industrial Average DJIA,
+ 0.64%
Climbing 0.6%, the S&P 500 SPX Index,
+ 0.69%
Gain 0.7% and Nasdaq Composite,
+ 0.76%
advancing by 0.8%.

The Federal Open Market Committee is scheduled to start its two-day meeting on Tuesday, and a decision on the interest rate is expected Wednesday afternoon.