U.S. stocks could fall 10% as ‘pain trade’ takes hold before bouncing back later in the year

A team of strategists led by Michael Hartnett told clients in a note on Friday that U.S. stocks could fall 10% from current levels before rallying later this year as investors start to expect a less aggressive policy stance from the Federal Reserve.

Stocks could slide as the U.S. economy slows and corporate earnings weaken. But there could be a light at the end of the tunnel.

A “recession trade requires patience,” he said in a note to clients on Friday.

He described the dynamic as a “pain trade,” meaning stock markets are at risk of losing ground until the Federal Reserve finally signals that it will start cutting interest rates.

The “pain trade is up ’til Fed rate forecasts, yields, credit spreads trough signal peak Goldilocks,” he said.

Markets strategists sometimes use the term “goldilocks” to refer to a not-too-hot, not-too-cold economy that continues to grow without stoking intense bouts of inflation. Such an environment is typically ideal for risk assets, as investors experienced during the decade that followed the financial crisis.

Following the economic data released Thursday, which showed the labor market chugging along as inflation continued to recede, Hartnett said it doesn’t get more “goldilocks” than that.

Hartnett sees the S&P 500
SPX,
+0.40%
positioned to trade between 3,600 and 4,200 but expects the former ahead of the latter. That’s actually the opposite of what Stifel Chief Equity Strategist Barry Bannister had to say earlier this week.

Bannister sees a window for a stock-market rally in the first six months of this year, but then trouble in the latter half. Among his concerns are inflation turning back up later in the year, forcing the Fed to tighten financial conditions.

And: The Fed has won its ‘war’ against inflation. Now it needs to stop hiking interest rates, JP Morgan analyst says

A reminder that all really isn’t that rosy came from JPMorgan JPM CEO Jamie Dimon who rattled markets on Friday with his warning that geopolitical and inflation “headwinds” were real concerns and “they may not go away.”

Read: JPMorgan, Wells Fargo, Bank of America and Citi beat earnings expectations, but worries about ‘headwinds’ remain

Hartnett highlighted notable inflows to investment-grade bond funds and emerging-market bonds and stocks in his note as well. On the flip side, U.S. funds have seen outflows. European markets have outperformed the U.S. so far this year, with the Euro Stoxx 50
FESX00,
+0.48%
up 6.2% in that time, compared with 3.5% for the S&P 500.