- Investors should expect further volatility in the S&P 500 in 2023 as investors update their economic outcome probabilities, UBS Global Wealth Management said Tuesday.
- "Fatter" tail risks for the market would stem from divergences in activity between the goods and services sectors of the economy and the Federal Reserve's path of rate hikes.
Big monthly swings in the S&P 500 will likely extend into next year as investors weigh moves by the Federal Reserve and economic data to gauge whether there will be a soft landing or a recession for the world's largest economy, UBS Global Wealth Management said Tuesday.
"Fatter" tail risks for the market would stem from divergences in activity between the goods and services sectors of the economy and the Federal Reserve's path of rate hikes.
"[Expect] more volatility and large market swings exacerbated by positioning as investors update their economic outcome probabilities in reaction to each new data point and Fed utterance," Jason Draho, head of Asset Allocation Americas at UBS Global Wealth Management, in a note.
In 2022, the S&P has been exhibiting a "pendulum-like return pattern," he said. "Large month-to-month swings could continue well into next year before the economy's eventual destination becomes clear."
From the central bank side, the Federal Open Market Committee last week indicated that investors should expect a slower but higher cycle of rates hikes moving forward. That implies that the odds of a fifth straight hike of 75 basis point in December have declined while the odds of a terminal federal funds rate over 5% have risen.
Going slower gives the Fed more time for impact assessment and reduces the risk of overtightening. "A soft landing that could materialize in the absence of too much tightening becomes slightly more plausible," Draho said.
On the other hand, a slower pace of rate hikes could lead the Fed to work harder than it had to because inflation has become more entrenched. "That increases the risk of a harder landing, though it also pushes out the timing of when that would happen," he said.
Meanwhile, the divergence in activity between the goods and services sectors in the slowing US economy adds to the risk of tail outcomes, UBS said. Services this year have grown "solidly" this year as consumer spending patterns normalize after the height of the pandemic while the goods sectors have contracted or are close to it. In a typical economic cycle, the two sectors would be moving somewhat in sync.
"Optimistically, these forces could balance out as the pendulums gradually revert to normal in-sync patterns, allowing the economy to muddle along to a softish landing," Draho said. "Pessimistically, ongoing services sector strength may keep the labor market and inflation from cooling sufficiently, thereby forcing the Fed to keep hiking rates until a hard-landing recession is all but assured."
The month-to-month swings in the S&P 500 this year include October's total return of 8% after September's drop of 9.3%, the worst monthly loss since March 2020 when the COVID outbreak was spreading worldwide.
"Investors shouldn't position their portfolios for either of these tail scenarios, but higher probabilities for both do have market implications," said Draho.