Why this bear market rally may have further to go

The 2023 outlook is flashing red, but for investors the looming US recession may not mean an end to the bear market rally just yet. 

A bear market rally that’s pushed the S&P 500 index some 12% higher since mid-October has further to go before a US recession triggers a big sell-off, a City bank has forecast.

Deutsche Bank’s world outlook for 2023 contains a base case that the US benchmark will move from below 4,000 to finish this year at 4,200 and the first quarter at 4,500.

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An end in sight to the US rates tightening cycle has been behind this latest rally, which followed a recession-like decline of around 24% for the S&P 500 earlier in the year.

Recessionary periods typically see an average of three sizeable bear market advances of more than 10% but Deutsche Bank points out there’s already been five in the current cycle.

It reckons the current bear market will last well into next year due to a decline in implied volumes and squeeze on systematic strategy positioning.

Deutsche Bank sees the US market as being flat to slightly lower in the second quarter of 2023 before a significant decline in the S&P 500 to 3,250 as recession takes hold.

But if markets follow the usual “recession playbook” of bottoming less than halfway through a downturn, the bank believes the S&P 500 could yet finish 2023 back at its first-quarter peak.

For counterparts at Bank of America, their base case is for the S&P 500 to end next year at 4,000 but with a “bull” argument for 4,600.

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The bank’s economists predict a US recession from the first quarter of 2023, with GDP falling 0.4% across the year and the unemployment rate rising two percentage points to 5.5% by the first quarter of 2024.

Historically, recessions have resulted in average peak-to-trough declines for the S&P 500 of 30% and 20% for earnings per share.

However, the bank warns there are many more variables at play this time: “Some of the biggest risks that we see over the next 12 months are driven by the fact that things are different this time.” 

As well as an aggressive rate-hiking cycle in response to the worst inflationary pressure in more than 40 years, the bank points to ongoing geopolitical risks and urgency building around carbon emission reduction.

It adds that companies and consumers are less exposed to credit and leverage risk than they have been historically, which could mitigate earnings risk considerably.

But in turn, these healthier balance sheets mean the Federal Reserve may have to hike rates for longer to get inflation back under control.