The S&P 500 closed 2022 with its largest annual loss since 2008, down by 19.44 per cent, because of the Fed’s fastest pace of rate hikes since the early 1980s to curb record-high inflation, enacting four consecutive 75 basis points (bps) rate increases. At the Fed’s December policy meeting last year, the central bank slowed the pace of its rate hikes but remained hawkish, projecting the terminal rate to hit 5.1 per cent and rate cuts to only occur in 2024. As we head into 2023, we should expect recession to dominate market headlines with continued fears that the Fed could over tighten its monetary policy and tip the economy into a recession. Recession fears were compounded by the recently released ISM manufacturing data, which slipped below estimates to 48.4 from 49.0, with a reading below 50 signalling a contraction in activity.

Despite growing recession signals, the Fed appears steadfast on its hawkish rate hike trajectory. Minutes of the FOMC’s December 13-14 meeting showed the Fed reaffirming their hawkish rhetoric and pushing back against market expectations for rate cuts in 2023. Fed officials warned that an “unwarranted easing in financial conditions driven by public misperception” could hurt the Fed’s efforts to tame inflation. At the time of writing on Jan 5, 2023, market expectations remained at odds with the Fed, with Fed fund futures continuing to price in rate cuts in H2 2023. Additionally, US job openings, a key metric for the Fed, also fell less than expected to 10.46 million from 10.51 million, pointing to a still-tight labour market that may result in persistent wage growth, keeping inflation elevated. This is likely to put pressure on the Fed to continue keeping rates higher, to reduce labour demand.

In our view, we believe the Fed will continue to hold rates at restrictive levels for an extended period of time to prevent inflation from flaring up again as it did in the 70s and also to signal to the market that there will not be an easing anytime soon in 2023. From the current levels, rate cuts are unlikely to occur without a substantial decline in labour demand, wage growth, and inflation expectations. Therefore, we expect the S&P 500 to remain under pressure in Q1-Q3 2023 as the economy enters a mild recession, followed by a mild market recovery in Q4. Discussions about rate cuts and dovish commentary from the Fed may emerge in Q4 to support a mild market recovery. However, a sustained rebound appears unlikely unless the Fed starts cutting interest rates earlier than expected.

On a technical perspective, we maintain a bearish outlook on the S&P 500 in Q1-Q3 2023. Corporate profitability is likely to be negatively impacted by the extended duration of the Fed’s tightening cycle. We expect the S&P 500 to test support at the 0.382 and 0.236 Fibonacci levels at around 3,810 and 3,690, respectively; if broken, the index could head further down towards October 2022 lows of around 3,500 due to two main reasons:

⦁ The formation of a bearish engulfing candlestick pattern between Dec 30, 2022, to Jan 1, 2023, indicating that sellers may be gaining strength and serving as a bearish reversal signal.

⦁ The Moving Average Convergence Divergence (MACD) indicator also shows a bearish crossover signal as the MACD line is currently below the signal line and remains below zero. Similarly, the MACD histogram is also in negative territory, signalling bearish momentum.

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Ultimately, we maintain a bearish outlook on the S&P 500 in Q1-Q3 2023 as the US enters a mild recession and corporate earnings see a significant decline. We do not envision rate cuts in 2023. However, because markets are forward looking, investors may look past market weakness and focus on potentially improved fundamentals in 2024 as dovish commentary emerges from the Fed. This could drive a mild market recovery in Q4 and push the S&P 500 to around the 3,900-4,000 levels by year-end.

The writer is investment analyst at Phillip Nova