Stock market forecast: Why a 10% plunge is coming by the end of 2019

Stock-market investors are failing to fully price in the impact that higher interest rates will soon have on the economy, according to Francois Trahan, the newly appointed chief US equity strategist at UBS. Trahan's new year-end target for the S&P 500 implies a decline of about 10% as the effects of higher borrowing costs kick in with a lag.Visit Business Insider's homepage for more stories.Forget the stock market's dips over the last two weeks: a bigger plunge two years in the making is on its way, according to Francois Trahan, UBS' new chief US equity strategist.Trahan has come right out of the gate with a contrarian stock-market outlook that foresees a roughly 10% drop over the next few months. His year-end target for the S&P 500, of 2,550, is the second-lowest among the 25 chief equity strategists tracked by Bloomberg. The median forecast is 2,950. Investors who doubt that this correction is a real risk are part of the reason why Trahan says it's a distinct possibility. That's because the core of his thesis is what he considers a broad underestimation of the impact that the past few years of interest-rate hikes will have on the stock market. “There is a perception among some investors that the Fed's tightening cycle is already priced into US equities,” Trahan said in a recent note to clients. “This notion could prove to be a major surprise this year, a disappointing surprise that is.”Since late 2015, the Fed has raised its benchmark interest rate from near-zero to a target range between 2.25% and 2.5%. Despite these increases, rates have remained historically low, giving both the economy and stock market an accommodative environment to continue expanding. This climate is a key reason why the economy is on the verge of its longest-ever expansion. The flipside is that economic growth is now consistent with prior terminations of Fed tightening cycles, when the economy was transitioning into recessions, Trahan said. At the end of the four Fed tightening cycles since 1985, real gross domestic product was above 3%.Read more: 'Eerily similar': A Wall Street chief equity strategist explains why Trump's shocking trade U-turn is the perfect trigger for another stock plungeAlthough growth looks strong today, it usually takes nearly two years for interest-rate increases to slow economic growth, according to Trahan. Given that the most recent rate hike was in December, the economy should slow through the end of 2020, he said. However, the stock market only discounts such events about six months into the future, which explains why it is still trading with the perception that the economy is doing just fine. The time “disconnect” is why investors will be disappointed at the market's returns by the end of the year, according to Trahan. “Every proxy of interest rates that we use to forecast the future trend in US Leading Economic Indexes tells us that they will likely trend lower this year,” he said. He continued: “As we see it, the likeliest path to outperformance remains with a risk-off posture and we favor counter-cyclical sectors and stocks exhibiting low volatility and high visibility.”Trahan's warnings were accompanied by a number of caveats, although they did not outweigh his final call for a 10% decline in stocks.He says this expansion could go on for longer than expected, thanks to the many years of zero interest rates that had no precedent. He also believes that China's economic growth (or implosion) is a major wildcard that's somewhat misunderstood by US investors. And finally, Trahan notes that, compared to 2006, the S&P 500 has more stocks — an additional 22 — that are counter-cyclical, meaning they have a low sensitivity to changes in the economy.