The stock market is sliding because investors fear recession more than inflation

A stock market paradox, in which bad news for the economy is seen as good news for stocks, may have run its course. If so, investors should expect bad news to be bad news for stocks heading into the new year – and there could be a lot of it.

But first, why should good news be bad news? Investors have spent 2022 largely focused on the Federal Reserve and its rapid series of sharp rate hikes aimed at keeping inflation in check. Economic news pointing to slower growth and less fuel for inflation could serve to lift stocks on the notion that the Fed might start to slow the pace or even begin to consider future rate cuts.

Conversely, good news on the economy can be bad news for stocks.

So what has changed? Last week saw November consumer price index weaker than expected. Although still very hot, with prices up more than 7% year-on-year, investors are increasingly convinced that inflation has probably peaked at a high of around four decades above 9% in June.

See: Why November’s CPI data is seen as a ‘game changer’ for financial markets

But the Federal Reserve and other major central banks have signaled they intend to continue raising rates, albeit at a slower pace, through 2023 and likely keep them high for longer than expected. by investors. This stokes fears that a recession is becoming more likely.

Meanwhile, markets are behaving as if the worst of the inflation scare is in the rearview mirror, with recession fears now looming on the horizon, said Jim Baird, chief investment officer of 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 phone interview.

Markets have “probably returned to a period where bad news is bad news, not because rates are going to worry investors, but because earnings growth is going to falter,” Baird said.

A “reverse Tepper swap”

Keith Lerner, co-chief investment officer at Truist, argued that a mirror image of the backdrop that produced what became known as “Tepper trading”, inspired by hedge fund titan David Tepper in September 2010, could form.

Unfortunately, while Tepper’s prescient call was for a “win/win scenario”. the “Tepper reverse trade” presents itself as a lose/lose proposition, Lerner said, in a Friday note.

Tepper’s argument was that the economy would either improve, which would be positive for stocks and asset prices. Or, the economy would weaken, with the Fed intervening to support the market, which would also be positive for asset prices.

The current setup is one in which the economy will weaken, rein in inflation, but also squeeze corporate profits and defy asset prices, Lerner said. Or, on the contrary, the economy remains strong, alongside inflation, with the Fed and other central banks continue to toughen the policyand difficult asset prices.

“In either case, there is a potential headwind for investors. To be fair, there is a third way, where inflation goes 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 were in full swing on Thursday, when November retail sales recorded a decrease of 0.6%, beating forecasts of a 0.3% drop and the biggest drop in nearly a year. Additionally, the Philadelphia Fed’s manufacturing index rose but remained in negative territory, disappointing expectations, while the New York Fed’s Empire State index fell.

Read: Still a Bear Market: Falling S&P 500 Signals Stocks Never Hit ‘Flight Velocity’

Stocks, which had posted moderate losses after the Fed raised interest rates by half a percentage point the day before, fell sharply. Stocks extended their decline on Friday, with the S&P 500 SPX,
-1.11%
recording a weekly loss of 2.1%, while the Dow Jones Industrial Average DJIA,
-0.85%
lost 1.7% and the Nasdaq Composite COMP,
-0.97%
fell 2.7%.

“As we move forward into 2023, economic data will have more influence on equities because it will give us the answer to a very important question: how bad will the economic downturn be? key 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 of slowing growth,” said Tom Essaye, founder of Sevens Report Research, in a Friday note.

Recession Watch

No one can say with absolute certainty that a recession will occur in 2023, but there’s no doubt that corporate earnings will be under pressure, and that will be a key driver for markets, Plante Moran’s Baird said. And that means earnings have the potential to be a significant source of volatility in the year ahead.

“If in 2022 the story was inflation and rates, for 2023 it will be earnings and the risk of recession,” he said.

This is no longer an environment that favors high-growth, high-risk stocks, when the cyclical factors may well set in 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 bent, and sees “better opportunities below the market surface,” such as the equally-weighted S&P 500, a proxy for the average stock.

Highlights of the economic calendar for the week ahead include a revised outlook for third-quarter gross domestic product on Thursday, as well as November’s index of major economic indicators. On Friday, consumption and personal spending data for November, including the Fed’s favorite inflation gauge, are expected to be released.

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