Chronicle: Another leg down? The markets are not yet prepared for the recession

A trader works on the floor of the New York Stock Exchange (NYSE) in Manhattan, New York, U.S., May 20, 2022. REUTERS/Andrew Kelly

LONDON, May 27 (Reuters) – One of the worst starts to the year in decades could suggest investors are already prepared for an economic storm to come, but it is far from clear that recession risks have taken into account or fully assessed.

The reasons for the 15-20% drop in benchmark equity indices this year are well documented – rising interest rates to rein in soaring post-pandemic inflation rates that have been exaggerated by a price shock from energy and food related to Ukraine which also weighed on household incomes and corporate margins.

Add heightened geopolitical risks more broadly, “zero COVID” lockdowns undermining China’s growth, ongoing supply chain issues and chip shortages – and the sky darkens further. And while a northern summer could ease immediate energy pressure, there is little clarity in Europe about what will happen next winter if Russian gas supplies are cut.

It’s no surprise, then, that economists are warning of a coming global recession even as many parts of the world appear to simply be riding the crest of a post-pandemic reopening wave.

The main policy debate centers on whether the US Federal Reserve and other central banks will feel the need to tighten monetary policy into “tight” territory that deliberately slows economies to bring inflation down – or whether growth will pick up before we even have to consider breaking above so-called “neutral” rates another 150 basis points from here.

Either way, it’s not a great picture of the activity to come.

Just this week, World Bank President David Malpass feared the worst for global output. “It’s hard to see at the moment how we’ll avoid a recession,” he said on Wednesday. Read more

Washington’s Institute for International Finance halved its forecast for global growth to just 2.3% for this year and said “the risk of a global recession is high”. Read more

Commercial banks such as Deutsche Bank and Wells Fargo are now predicting a US recession at some point over the next 12-18 months, while many houses see Europe there this year.

Economic data surprises are turning sour, with the US and Chinese indices renewing and now more negative than they were seen on the first Omicron variant six months ago. And this time with global oil prices 50% higher than they were last fall and, at nearly 3%, 10-year dollar borrowing rates more than double November levels. .

And U.S. housing markets are beginning to creak under the weight of rising mortgage rates and soaring material prices.

So, on many levels, the outsized fall in stock prices is more than well founded – the only question is whether it is enough.

ANOTHER LEG DOWN?

With interest-rate-sensitive tech stocks taking a hit and the Nasdaq index down 25% year-to-date, the temptation is to think there’s a lot on board already.

Standard valuations that look at prices as a 12-month forward earnings ratio show falls of 25-30% in the US and Europe since January and could generally suggest a bargain or two.

The problem is that there has been little to no downward revision to the overall 12-month or full-year 2023 earnings forecast, despite the clouded outlook for many tech, digital and by subscription, as well as those exposed to China and chip shortages – or even energy rationing in Europe.

And while we’ve seen a decline in Wall St’s most expensive stock market valuations since the dot.com bubble 20 years ago, they’re still above 30-year averages and only returning to their levels on the eve of the pandemic. The picture is slightly better in Europe, but not by much.

But the unflappable earnings projections are perhaps the most alarming aspect of current valuations.

After all the shocks and interest rate hikes since January, the overall full-year earnings growth forecast for the S&P500 has actually risen more than a full percentage point and the projections for 2023 barely budged at just under 10%.

Many fear that there is a very heavy shoe waiting to fall here if recession fears materialize. And if earnings forecasts are revised down over the next few months and throughout Q2 earnings season, will stocks simply get more expensive again, or will prices need to be further reduced?

“The question is, will the stock market go ahead and discount the earnings cuts we think are coming or force companies to formally cut their forecasts?” Morgan Stanley strategists pondered this month, adding that “bear market rallies” are likely, but another 15-20% drop for the S&P500 is then likely.

This is still a minority opinion, however.

JPMorgan’s team still insists ‘risk-reward’ is positive for stocks over the medium term, pointing to a bottom in China, a Fed pivot away from relentless tightening and a spike in the dollar as reasons. to think that the worst is over for the markets.

And while many asset managers – like Blackrock this week – seem to think the fabled “soft landing” is still possible, they are keen to stay neutral on stocks while it unfolds. Read more

DWS Chief Investment Officer Stefan Kreuzkamp remains bullish on stocks despite the shocking start to this year.

But it adds a fairly basic exit clause – “the precondition that risks do not worsen – no recession in the United States and Europe – and that the US central bank manages to contain inflation without reducing inflation too much. economic growth”.

It can be a nervous wait.

The author is Finance and Markets Editor at Reuters News. All opinions expressed here are his own.

by Mike Dolan, Twitter: @ReutersMikeD. Graphics by Danilo Masoni; edited by David Evans

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