The stock market isn't out of the woods yet as 2023 approaches, according to Bank of America.
The bank released its 2023 outlook and while it expects flat returns for the S&P 500, it also expects big volatility.
Here's why BofA thinks the S&P 500 could fall as much as 24% next year to new bear market lows.
The bear market decline in stocks could spill over into 2023 as the Federal Reserve's quantitative tightening is likely to spark liquidity risks in different areas of markets, according to Bank of America's equity strategist Savita Subramanian.
The bank's 2023 outlook includes a base-case projection of flat returns, with the S&P 500 finishing the year at 4,000.
But even a year of flat returns could include some big volatility between now and the end of 2023, with BofA's bear case scenario sending the S&P 500 24% lower from current levels to 3,000. That would represent a new low in the current bear market cycle.
"Unprecedented leverage risk" currently lies with governments and central banks moreso than consumers and businesses. And that could lead to liquidity risks popping up in "odd places" as the Fed continues with the reduction of its $8.6 trillion balance sheet at a pace of $95 billion per month, according to the note.
There have already been rumblings of liquidity risks in the US Treasury market, and those concerns are likely to grow more pronounced next year because the "Fed and China have left the building," Subramanian said, referencing the fact that two of the Treasury markets largest buyers are no longer buying new Treasury issues.
That liquidity risk could ultimately spillover into stocks because the Treasury market is a key pricing function of both credit and equity markets via the risk-free rate. As buyers exit the Treasury market, it naturally tightens financial conditions and sends the risk-free rate higher, which leads to a bigger discount for stock prices and puts corporate debt financing on shakier ground.
Liquidity risks aren't the only concern for investors next year. The elephant in the room is a potential recession, and according to BofA, it will be hard to avoid.
But any recession will likely not be "your mom and dad's" recession, according to the note, because there's plenty that's different this time around.
Namely, businesses and consumers have solid balance sheet health and are less exposed to credit and leverage risk relative to prior recessions. Meanwhile, businesses have a big incentive to invest in their businesses to remain competitive, which is good for the economy.
But a healthy consumer ultimately means a more aggressive Fed.
"The key implication here is positive as a floor for earnings but may be negative for markets: no 2008-like bailout is necessary, and the Fed may have [to] hike longer and engage in quantitative tightening to curb inflation, leading to a higher discount rate for stocks," Subramanian said.
A recession could ultimately be a buying opportunity for investors, according to the note. "The market typically bottoms six months before the end of a recession, so buy in 1H based on our economists forecast of the recession ending by [the] third quarter of 2023," Subramanian said.
To position for a volatile, but flat year ahead, Subramanian recommends investors get overweight stocks in the financial, energy, consumer staples, and utility sectors. The bank expects a 9% decline in S&P 500 earnings per share next year to $200.
"We see several reasons for investors to shift toward a higher quality portfolio today. The secular case is that of tighter liquidity going forward. The cyclical case is slowing profits growth, rising volatility. The fundamental case? Valuation - Quality is inexpensive by our work, and is likely to re-rate," Subramanian said.
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