The stock market has been making a strong recovery after a challenging bear market, but it’s not out of the woods just yet. While some experts are concerned about higher interest rates, others are worried about potential earnings disappointments. However, one risk that stands out clearly is the draining of liquidity in the global banking system.
Growing Calls for a Market Correction
The S&P 500 has climbed approximately 27% since hitting a low point in early October, leading to an increase in calls for a correction. The index is now more expensive, trading at 19 times aggregate forward earnings-per-share estimates compared to 15 times at the beginning of the rally. Market participants are hopeful that the Federal Reserve will soon halt its interest rate hikes, which would stabilize the economy and support corporate profit growth. However, if the Fed maintains high rates for an extended period instead of lowering them, the economy could suffer delayed negative effects, potentially leading to disappointing sales and earnings for companies. Despite these concerns, earnings are currently not hurting the market, as evidenced by the positive bank earnings released on Friday.
Global Liquidity as a Key Risk
One critical risk that cannot be ignored is the relationship between the stock market and global liquidity, which refers to the availability of money. The global M2 money supply, including cash in checking and savings accounts as well as money-market-fund assets, has remained flat year over year after experiencing a 5% decline in 2022, according to Morgan Stanley. Central banks have been raising rates by selling assets, effectively extracting cash from the banking system and reducing the amount of money available for lending and spending. Consequently, traders and portfolio managers will have less capital at their disposal, which will require them to practice greater caution when making stock investments.
The Stock Market’s Vulnerability to a Correction
According to a report by Morgan Stanley, the S&P 500 index could potentially face a 15% drop, putting it somewhere between 3700 and 3800. This prediction is based on the historically tight correlation between M2 and the index. While this may seem unlikely given that the market is aware of central banks reducing liquidity, there is a reason behind Morgan Stanley’s forecast.
The mechanics of having less money in the system could have a detrimental effect on the demand for stocks. Portfolio managers have already reduced their cash holdings as they have been buying up stocks over the past few months. Additionally, consumers may also begin to spend less as they deplete their cash reserves. Even though this may not be evident in second-quarter earnings reports, it could eventually impact corporate earnings.
Furthermore, if the Federal Reserve does not cut interest rates, there won’t be any additional liquidity injected into the U.S. economy. This lack of stimulus could negatively impact the market. It is worth noting that unexpected decisions by the Fed, such as a decision to not cut rates, tend to have a negative effect on the market.
In essence, while the stock market has shown signs of recovery from the bear market, it still remains vulnerable to a normal and necessary correction.