What’s priced in as recession concerns grow

Market Perspective

May 20, 2022

What happened

The S&P 500 is on pace for its seventh-straight weekly loss. This has only occurred four other times since 1950, with the last such streak occurring in March 2001. The approximate cause of the steady decline is multi-faceted, but recession risks have taken center stage on the carousel of concerns in recent weeks.

Last month, a CNBC survey indicated 81% of adults believed a recession was likely in 2022. We have also seen an uptick in this view from business owners and CEOs from both small and big firms alike. To add to this, several large retail stocks saw significant declines this week on disappointing earnings reports that highlighted inflation, margins, inventory, supply chain challenges, and shifting consumer preferences. Concurrently, this week, Federal Reserve (Fed) Chair Jerome Powell reiterated his commitment, at least near term, to continue to raise short-term interest rates to tame inflation, even in the face of some signs of economic softness.

Our take

Given the confluence of challenges, it’s understandable why the market is under pressure and the general mood is dour. And, we acknowledged the wider range of outcomes in our early April downgrade of equites to neutral (stocks have dropped more than 10% since then). That said, our macro team acknowledges risks are growing but still places U.S. recession risk over the next 12 months at closer to 25%.

As an offset to some of the current economic challenges, the substantial increase of $2.9 trillion in consumer cash balances since 2019 should help cushion the downside. Although employment is set to come off a boil, the job market remains relatively sturdy, and wage growth is strong. Part of the weakness seen in retailers this week is the transition from buying stuff (goods) to purchasing services and experiences. The service side of the economy is a much larger part of the economy, and travel and leisure is booming. Health care/medical spending is also rebounding, particularly discretionary spending. Notably, retail sales for April and industrial production showed continued strength. This isn’t meant to gloss over the challenges, but simply to suggest not all the data is grim. 

While the debate will continue, perhaps a better question for investors to ask is what is priced in at current levels? And, if we do go into recession, what could that mean for markets?

A historical perspective around recessions

Historically, the S&P 500 has fallen an average of 29% around recession (median of 24%). With the S&P 500 currently showing a peak-to-trough decline of almost 19%, the market is effectively already pricing in a 60%-75% chance of recession based on the average and median.

For argument’s sake, let say we do go into recession. What would that mean for stocks? Using the average and median decline around recessions brings us to an S&P 500 range of roughly 3400 to 3650 from Thursday’s close of 3900. This represents another 7% to 13% downside. This would make an unbelievably brutal market feel that much worse, and, of course, markets could go beyond the average.

But, here is another important point to consider. Once stocks have found their low during a recession, the average one-year forward return is 40%. Said another way, even if stocks went down to 3400, using the average rebound, stocks would be near 4800. The other thing to remember is stocks tend to bottom several months before a recession is over and often when we hit peak pessimism. This happens when investors think to themselves, “I can’t think of one reason for the markets to go up.” All the headlines are negative.

As a recent example, after a 34% drop at a record speed, stocks bottomed in March of 2020. This was still at the very early stages of the pandemic. When there was no vaccine. When the world was still largely shutdown. And, when uncertainty reigned.

 

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