The stock market is falling because investors fear recession more than inflation
A stock market paradox, in which bad news about the economy is seen as good news for stocks, may have come to an end. If so, investors should expect bad news to be bad news for stocks heading into the new year, and there may be plenty.
But first, why would good news be bad news? Investors have spent 2022 largely focused on the Federal Reserve and its rapid series of big rate hikes aimed at curbing inflation. Economic news pointing to slower growth and less fuel for inflation could serve to lift stocks on the thought that the Fed may start to slow down or even start contemplating further rate cuts.
On the contrary, good news about the economy. could be bad news for actions
So what has changed? last week saw a softer-than-expected November consumer price index reading. While it’s still doing very well, with prices rising more than 7% year-over-year, investors are increasingly confident that inflation likely hit a roughly four-decade high above 9% in June.
See: Why the November CPI data is considered a ‘game changer’ for financial markets
But the Federal Reserve and other major central banks have indicated they intend to continue raising rates, albeit at a slower pace, through 2023 and likely to keep them raised for longer than investors had anticipated. That is stoking fears that a recession is becoming increasingly likely.
Meanwhile, markets are behaving as if the worst of the inflation scare is in the rear-view mirror, with fears of a recession now looming on the horizon, said Jim Baird, chief investment officer at Plante Moran Financial Advisors.
That sentiment was bolstered by manufacturing data on Wednesday and a weaker-than-expected retail sales reading on Thursday, Baird said in a telephone interview.
Markets are “probably returning to a period where bad news is bad news, not because rates are worrying investors, but because earnings growth will falter,” Baird said.
A ‘reverse Tepper trade’
Keith Lerner, Truist’s co-chief investment officer, argued that a mirror image may be forming of the backdrop that produced what became known as the “Tepper trade,” inspired by hedge fund titan David Tepper in September 2010.
Unfortunately, while Tepper’s prescient call was for a “win/win scenario.” the “reverse Tepper trade” is shaping up to be a lose/lose proposition, Lerner said, in a note Friday.
Tepper’s argument was that the economy was going to improve, which would be positive for stocks and asset prices. Or, the economy would weaken and the Fed would step in to support the market, which would also be positive for asset prices.
The current setup is one in which the economy will weaken, keeping inflation under control but also hurting corporate profits and challenging asset prices, Lerner said. Or instead, the economy remains strong, along with inflation, with the Fed and other central banks. keep toughening up the policyand challenging asset prices.
“In any case, there is a potential headwind for investors. To be fair, there is a third path, where inflation comes down and the economy avoids recession, the so-called soft landing. It’s possible,” Lerner wrote, but noted that the path to a soft landing seems increasingly narrow.
Recession jitters came to the fore on Thursday, when November retail sales showed a fall of 0.6%, beating forecasts for a 0.3% drop and the biggest drop in almost a year. In addition, the Philadelphia Fed’s manufacturing index rose but remained in negative territory, disappointing expectations, while the New York Fed’s Empire State index fell.
Stocks, which had posted moderate losses after the Fed raised interest rates a day earlier by half a percentage point, fell sharply. Stocks extended their decline on Friday, with the S&P 500 SPX,
posting a weekly loss of 2.1%, while the Dow Jones Industrial Average DJIA,
shed 1.7% and the Nasdaq Composite COMP,
Read: Still a Bear Market: S&P 500 Drop Indicates Stocks Never Reached ‘Escape Velocity’
“As we move into 2023, economic data will have a greater influence on stocks because data will tell us the answer to a very important question: How bad will the economic slowdown be? That is the key question as we enter the new year, because with the Fed on relative policy autopilot (more hikes to start 2023), the key now is growth and the potential damage from slowing growth,” said Tom Essaye. , founder of Sevens Report Research, in a note on Friday.
No one can say for sure that a recession will hit in 2023, but there seems to be no doubt that corporate profits will come under pressure, and that will be a key factor for markets, Plante Moran’s Baird said. And that means earnings have the potential to be a significant source of volatility in the coming year.
“If in 2022 the story was inflation and rates, by 2023 it will be earnings and the risk of recession,” he said.
It’s no longer an environment that favors high-risk, high-growth stocks, while cyclical factors may be gearing up for value-oriented and small-cap stocks, he said.
Truist’s Lerner said that until the weight of evidence changes, “we maintain our overweight in fixed income, where we focus on high-quality bonds, and a relative underweight in equities.”
Within stocks, Truist favors the US, a value tilt, and sees “better opportunities below the surface of the market” such as the equally weighted S&P 500, a gauge of the average stock.
Highlights of the economic calendar for next week include a revised look at third-quarter gross domestic product on Thursday, along with November’s index of leading economic indicators. On Friday, November consumption and personal spending data, including the Fed’s preferred inflation gauge, will be released.