Recession defies inflation as stock and bond investors’ biggest fear

It’s easy to want to dodge for cover given the carnage seen this year in stocks and bonds, especially with the Federal Reserve pledging an unconditional fight against high inflation.

While inflation is hitting a 40-year high still near the top of many investors’ list of concerns, another potential risk to markets has begun to lurk in the form of slower corporate earnings growth – and possibly the broader US economy.

“I would say there are certainly concerns that earnings expectations are falling again. Softening, but not falling off a cliff,” Jake Rimley, senior portfolio manager at Income Research + Management, said by phone.

Ahead of new corporate results starting in mid-July, analysts pinned the SPX for the S&P 500 Index,
+ 3.06%
Estimated second-quarter earnings growth rate is 4.3%, according to a report released Friday by FactSet, a level that would mark the lowest annual growth rate since the fourth quarter of 2020.

“You could argue that the bad news would remove some of the pressure from the Fed,” Rimley said, speaking of the Fed’s plans to significantly tighten financial conditions this summer, in an effort to cool spiraling inflation.

“They don’t want to break the consumer, the corporate bond market, or the banks’ balance sheets,” he said. “But it would take more than they did, in our view,” to avoid entrenching the high cost of living.

“The faster they do it, the better.”

Recession or inflation?

It is a delicate dance. The Fed wants to cool demand for goods and services, through starkly higher interest rates, but without overdoing it, driving workers out of their jobs by causing a recession.

San Francisco Federal Reserve President Mary Daly on Friday added her support for another big interest rate hike in July to target high inflation, without derailing the economy.

“The biggest fear is not this or that — it’s both,” said Mark Heppensal, chief investment officer at Penn Mutual Asset Management, about whether the fear of growth or inflation is most important.

The US economy contracted 1.4% year-on-year in the first quarter. He said by phone that with interest rates rising and financial conditions tightening, the economy could be on the path to a technical recession.

“It definitely feels like a period of stagflation, which is why we’re seeing a lot of swings in asset prices and interest rates.”

Stocks are up this week, with the S&P 500 SPX,
+ 3.06%
It ended up 3.1% on Friday, booking its best day in more than two years. But the broad market gauge is still down 17.9% for the year, in a bear market, with the Nasdaq Composite,
+ 3.34%
25.8% off so far in 2022, according to FactSet.

Dow Jones Industrial Average DJIA,
+ 2.68%
It’s up 5.4% on the week, but it’s still down 13.3% for the year so far.

ReadStagflation, deflation, soft landing, or stagnation – what Wall Street expects in the second half of 2022

layoffs tracking

A major component of 1970s-style stagflation was the combination of high inflation and a weak labor market. In comparison, the current employment picture is still very strong.

However, that could change quickly, if more companies start reporting disappointing corporate earnings, not just because a strong dollar hampers international sales, but more broadly from the cascading effects of inflation at 8.6%, a 40-year high.

“Inflation rhetoric is pulling back, while the recession narrative is making the headlines,” Bob Schwartz, chief economist at Oxford Economics, said in a note on Friday. “This pivot in sentiment is cycles through the financial markets.”

He also cited falling bond yields as a potential damage to the economic slowdown. Standard 10-Year Treasury Yield TMUBMUSD10Y,
3.135%
It was at 3.125% on Friday, far from the recent peak of 3.482% hit on June 14, according to market data from Dow Jones.

“Layoffs are creeping in and job offers are cancelled,” Schwartz said.

layoffs edge higher

Oxford Economics

Schwartz said that while “job seekers have more than enough positions to choose from,” he also echoed some of the concerns the senator expressed this week. Elizabeth Warren during Fed Chair Powell’s two-day testimony on Capitol Hill. Both stressed that the labor market could weaken as a result of the central bank’s anti-inflation tactics.

Namely, “the strong bargaining position that workers have enjoyed over the past two years may be eroded.”

Among the key economic data to be released: Monday will bring pending home sales for May, followed by April’s reading of the US S&P Case-Shiller home price index on Tuesday. Wednesday brings updated US GDP for the first quarter. Thursday has more inflation data for May.

Leave a Comment