• Wealth Management
  • June 6, 2022

Putting Recession Fears in Perspective

Are recent indicators of slowing growth a warning sign of impending recession or perhaps something less ominous?

Rising concerns about monetary tightening, corporate earnings disappointments and the risk of recession have been weighing more heavily on investors lately. Indeed, certain misses in corporate earnings last week shone a light on rising costs denting company profits and dampening consumer demand. Mounting concerns dragged stocks down in another volatile week, with the S&P 500 Index logging its seventh-consecutive weekly loss.

It’s all starting to look a lot like a classic “growth scare,” characterised by sharp pullbacks in stocks in anticipation of slowing economic growth. We certainly empathise with this sentiment and have even warned of the rising probabilities of an economic recession, encouraging investors to remain cautious and patient. At the same time, we believe investors should not overreact and conclude that a recession is inevitable.

Specifically, after massive and unsustainable overshoots in the V-shaped economic recovery from COVID-19, the slowing we’re observing now is more likely a return to pre-pandemic trends, rather than a real contraction in which demand falls below the long-term trend.

A Return from Extremes

For one, it seems inevitable that there was going to be some “payback” in corporate earnings this year after extraordinary 2020 and 2021 results that benefited from record government stimulus and skewed consumer demand toward goods and “stay-at-home winners” earlier in the pandemic. So, we’re not surprised to now see 2022 earnings facing some headwinds with fiscal stimulus ending and consumption beginning to balance toward services, not to mention inflation’s impact on companies’ costs. These challenges were reflected in last week’s notable profit misses in retail and tech.

We also see this shift playing out in economic data. The Citigroup Economic Surprise Index, which tracks whether a key set of economic data is coming in under, at or over expectations, has plummeted to a reading of -13, from nearly 70 a month ago. Manufacturing gauges are down, as are real personal disposable income and consumer sentiment. This may be disappointing but can also be seen as a return from extremes—that is, we may be simply decelerating from last year’s nearly 13% nominal GDP growth to something closer to 7.5% this year. An outright contraction in demand is unlikely, as still-strong household balance sheets and solid labour-market dynamics can continue to support consumer resilience.

One other thing to note: Recessions are usually characterised by excesses—in areas like inventory, manufacturing capacity or credit—that need to be wrung out of the system. We’re not seeing those kinds of overhangs this time. Excesses this cycle have instead built up in financial markets and asset prices themselves. The biggest beneficiaries—the highly valued but unprofitable businesses that have relied on negative real interest rates to support valuations—will be hurt now that monetary-policy tightening is in play, but we don't expect this to produce systemic economic pain. These excesses will likely get resolved through mergers and acquisitions or via the vast amounts of committed but uninvested private capital. 

Next Moves for Investors

Investors will need to carefully consider current market and economic developments to stay balanced in their views and in their portfolios. Markets still face potential company earnings revisions and negative economic surprises, which could produce another drop in stocks of up to 10%. But such a reset in markets is unlikely to completely upend the fundamental tailwinds from solid consumption and corporate capital investment.

Investors should use current volatility to move portfolios toward maximum diversification, quality factors and active management. Consider deploying fresh cash toward investment-grade bonds, international stocks and cyclical sectors such as financials, energy and industrials.

 

This article is based on Lisa Shalett’s Global Investment Committee Weekly report from May 23, 2022, “Throwing Around the ‘R’ Word”. Ask your Morgan Stanley Financial Advisor for a copy. Listen to the audiocast based on this report.