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UBS warns of a 'major surprise this year' that'll send stocks down 9%

Sam Ro
Managing Editor

While some may see the recent sell-off in markets as a clear buying opportunity, one top Wall Street strategist sees the market going a lot lower in the next several months.

“We expect the S&P 500 (^GSPC) to hit 2,550 by the end of 2019,” said Francois Trahan, UBS’s new head of U.S. equity strategy. This target represents a 9.2% drop from Monday’s closing price. (Trahan’s predecessor at UBS had a year-end target of 2,950.)

For Trahan, this is about the market mispricing something that has already happened: months of tightening monetary policy in the form of rate hikes by the Federal Reserve.

Bearish scenario in stock market with bear figure in front of red price drop chart.

“A Fed-induced slowdown where leading indicators (LEIs) erode until they fully reflect last year's rate hikes is the single biggest threat we see for equities,” Trahan wrote in a note to clients on Monday. “There is a perception among some investors that the Fed's tightening cycle is already priced into U.S. equities. This notion could prove to be a major surprise this year, a disappointing surprise that is.”

“Beyond the stock market's ability to discount future events”

The Fed has been hiking interest rates since December 2015. The current cycle has included four rate hikes in 2018 before the Fed went on pause. How is it possible for the market to be missing such a big story?

“Indeed, history teaches us that it takes a long time, almost two years, for a change in interest rates to influence the economy,” Trahan wrote. “Two years is well beyond the stock market's ability to discount future events, as its window of visibility is really only about six months.”

"The chart below shows the relationship between the S&P 500 and U.S. GDP. The key feature of this chart is the six month lead time built into it." - UBS

In other words, the economy may look good out to the horizon. But just beyond the horizon, an economic slowdown awaits.

“This is the disconnect, and likely the disappointment, for investors as leading indicators continue to erode throughout 2019, gradually digesting the lagged effects of the Fed's tightening cycle, and simultaneously weighing on the equity market,” Trahan wrote.

Unfortunately for those looking for some a more optimistic scenario from Trahan, this is it.

“Indeed, in an economy like the U.S., where interest rates pack a big punch, the Fed's actions are almost guaranteed to lead to an economic slowdown,” he wrote. “While there are some positives that should help offset the effects of slower growth on equities, we have to admit that historical comps have us more concerned about being too positive with our target rather than too negative.“

Trahan further notes that his 2,550 target for the S&P ”would leave the Index up 2% for the year, an improvement from last year’s 6% decline. While 2% will sound disappointing to many, it is above the average seen in similar backdrops across history, i.e., the year following an extended Fed tightening cycle.”

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Sam Ro is managing editor at Yahoo Finance. Follow him on Twitter: @SamRo

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