(Bloomberg) -- The widening disconnect between stocks and bonds suggests a 20% downside risk for equities if bonds are proved correct in pricing inflation volatility, according to modeling by JPMorgan Chase & Co. strategists.
“Bond markets are still pricing in a sustained period of elevated macroeconomic uncertainty, even if there has been some modest decline over the past three months,” strategists including Nikolaos Panigirtzoglou and Mika Inkinen wrote in a note. “By contrast, equity markets look ‘priced for perfection’ with the S&P now above a fair value estimate looking through the rise in macroeconomic volatility since the pandemic.”
JPMorgan’s view highlights how much investors across different asset classes are struggling to make sense of the market landscape since the pandemic. The divergence has been on full display this week, with the S&P 500 entering a bull market just as bets firm for another Federal Reserve rate hike in July and after central banks in Australia and Canada wrong-footed traders.
Investors have also been blindsided in the currency market as the dollar has largely maintained its strength, going against expectations for the greenback to lose momentum as the Fed’s tightening cycle peaks. A gauge of dollar strength gained 1.6% in May, its biggest for the same period since 2018.
At the same time, instead of becoming a growth driver in Asia after pandemic restrictions ended, Chinese stocks tanked and entered a bear market.
Meanwhile, bond yields have remained relatively range bound on the prospect that the Fed will pause soon, but are still at risk from inflation volatility, according to the strategists. “If bond markets were to look through the rise in inflation vol since early 2021, 10-year real US Treasury yields could decline by around 70 basis points,” they wrote.
JPMorgan also said that euro-area equity indexes are pricing in little recession risk, with its model showing implied recession probability of only around 9%.
(Updates with dollar strength in fourth paragraph, euro-area equities in last paragraph.)
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