Wells Fargo predicts 10% correction in S&P 500 amid worsening economic conditions

Wells Fargo & Co. analysts have warned that the S&P 500 is likely to experience a 10% correction in the coming three to six months, as the US enters a recession in the second half of 2023. The bank’s economists have anticipated this event since before the collapse of Silicon Valley Bank last month, citing aggressive monetary policy, potential capital and liquidity issues catalyzed by the bank crisis, and a consumer that is increasingly reliant upon credit to sustain spending as the primary factors that will drive equity downside.

According to Chris Harvey, the bank’s head of equity strategy, the “economic malaise” that was expected by the firm prior to the bank crisis has moved toward an outright recession in the second half of the year. Harvey believes that the yield curve inversion and increasing reliance by consumers on credit have contributed to the bearish reversal in the bank’s view on stocks.

Wells Fargo has maintained its 2023 S&P 500 price target of 4200, but believes that the risk/reward over the next six months is skewed to the downside, with a correction expected to bring the SPX down to 3700. The bank’s lower view of 2023E SPX net margin (11.2% vs prior 11.6%) is reflected in the slashed 2023 S&P 500 EPS estimate to $200 from the prior $210. For 2024, Wells Fargo expects the S&P 500 to earn $213.

US equities were largely unscathed in the first quarter of 2023, even as investors faced rising recession fears, warnings about an earnings rout, and an unprecedented bank crisis. The S&P 500 has risen roughly 7% this year, driven by a drop in Treasury yields and a perceived pivot by the Federal Reserve on interest rates, according to Wells Fargo. However, the recent rally has started to lose steam as investors await a murky earnings season and concerns around the financial system linger.

Wells Fargo’s analysts believe several factors will trigger the downside in equities, including the potential capital and liquidity issues catalyzed by the bank crisis, a consumer that is increasingly reliant upon credit to sustain spending, and aggressive monetary policy. They also expect that in this economic downturn, S&P 500 net margins will contract by a little over 100bps y/y after a tremendous post-pandemic run.

“If we assume the Fed tightening cycle ended in March (that’s still a coin toss), the near-term relief rally appears already reflected in stocks,” Harvey wrote. “Typically, the market continues to rally over a three-month period; however, it may not be a fair comparison because the tightening cycle may not be over, and margin compression is expected to outweigh a Fed pivot.”

While Wells Fargo has maintained its year-end price target of 4200, the recent note to clients suggests that the resilience of US equities this year will be short-lived, with a worsening economic picture likely to send the market down in the coming months. The S&P 500 is currently trading modestly higher in pre-market on Tuesday, and “within spitting distance of our 4200 SPX target,” say the analysts.