The era of liquidity-induced gains is over, and the S&P 500 will just eke out a modest gain next year as the market struggles against Fed messaging, BMO says

A big screen display of stock prices hangs behind traders working at the New York Stock Exchange NYSE.
A big screen display of stock prices hangs behind traders working at the New York Stock Exchange NYSE on May 9, 2022.Michael Nagle/Xinhua via Getty Images
  • BMO Capital Markets sees a modest gain for the S&P 500 in 2023 but investors will likely travel a rough road to get there.

  • The market's groundwork is an "ongoing tug-of-war between Fed messaging and market expectations."

  • BMO said investors are likely seeing the days of liquidity-induced gains behind them.

The S&P 500 may travel higher in 2023 but the gain may be modest and the path to get there uneven as investors continue to navigate around the Federal Reserve's signals on monetary policy, according to BMO Capital Markets.

The firm's 2023 market outlook published this week said investors are likely seeing the days of liquidity-induced gains behind them.

"For all intents and purposes, 2022 will likely be remembered within the world of investing as the year when reality truly did bite. Long gone are the days following the Great Financial Crisis of monetary slack and mostly easy gains for both stocks and bonds," Brian Belski, BMO's chief investment strategist, wrote.

"But the news is not all dire. In fact, we believe this 'great unwind and return to normalcy' is actually very good news – with some bumps and bruises along the way," he said.

Bumps may be prevalent in 2023. "For the first time in many years, our enthusiasm for stock market performance potential next year is relatively tempered," said Belski. The firm put a target of 4,300 on the S&P 500 next year, representing 5% upside from Thursday's level.

The base-case outlook centers on the US economy entering a mild recession next year amid aggressive interest rate increases by the Fed to tame hot inflation.

Fed funds futures pricing on the CME FedWatch tool suggests most investors widely expect the key rate to go as high as 5% from the current level of 3.75%-4%. BMO expects the Fed to raise interest rates through May 2023.

"Unfortunately, we believe it will be difficult for stocks to finish 2023 much higher than current and anticipated levels given the ongoing tug-of-war between Fed messaging and market expectations," Belski said. "From our perspective, the Fed has been crystal clear in their intentions – which means at least a few more Federal Open Market Committee meetings of rate hikes followed by a prolonged pause period, something that we do not believe the market has fully discounted."

Future consumer price inflation reports that are hotter than expected will likely spark an "overreaction" to the downside in stocks, the firm added. The market also will likely experience heightened volatility in both directions during the first half of 2023 until overall inflation levels trend downward throughout the second half of 2023.

The S&P 500 could retest its current cycle low or even establish a new one – "although if that does happen it is not likely to be much lower than the previous one, in our view, and in no way alters our outlook," the firm said.

Earnings for S&P 500 companies may contract by roughly 5% to $220 a share in 2023 from this year given the macro circumstances.

"Stated differently, earnings are likely to be down because we believe that is what needs to happen for inflation expectations to come down (i.e., profit margin deterioration) and for the Fed to finally step aside," Belski wrote.

"Fortunately, we think this is well understood by investors and believe that the market will care more about falling inflation than a slight earnings decline – and maybe even more so than the prospect of a mild recession."

Read the original article on Business Insider