When the economy contracts next year, no one should be surprised. We’re facing the most predicted recession in history — and investors don’t seem to care.
A recession in Europe and the UK is already the median of economic forecasts, while the US median forecast for next year is a paltry 0.2% growth, according to Consensus Economics, the third lowest since 1989.
The Wall Street Journal’s regular poll found that economists expect a 63% recession next year. And a Federal Reserve Bank of Philadelphia survey of economists and investors shows expectations that gross domestic product will fall by three or four quarters are by far the highest since they began in 1968.
Of course, just because economists are confident in their forecasts doesn’t mean they’re right. Since the beginning of this Fed poll in Philly, a year ahead, not a single recession has been spotted. Economists completely overlooked the recessions of 1990, 2001 and 2008.
Are economists right this time? And if so, does that mean stock prices and bond yields should be higher or lower?
The cynics among us (yes, myself included) will be tempted to answer both with a duh. Obviously economists still don’t have a crystal ball and a recession would of course mean lower stocks and probably lower bond yields as it always has.
However, there are reasons to doubt it.
Start with the economists. Like generals, economists are really good at fighting the last war. They build models that incorporate past problems and are constantly overwhelmed by new problems. This time they think they understand because the problem for the economy is well understood: a central bank aggressively raising interest rates to fight inflation.
“People think they’ve seen this film a few times now and they appreciate the importance of central banks being late [to tighten] and make a soft landing more difficult,” says Sushil Wadhwani, a former Bank of England policymaker and now chief investment officer at hedge fund QMA Wadhwani.
SHARE YOUR THOUGHTS
Do you think the US economy will contract next year? Why or why not? Join the conversation below.
The Fed hasn’t hiked rates so quickly since Chairman Paul Volcker’s attack on inflation in the late 1970s. At that time, two recessions followed in quick succession.
Economists and investors alike have also learned to value a market indicator that has historically preceded recessions, the inverted yield curve, when yields on long-dated bonds are lower than those near maturity. The 10-year Treasury yield is now 0.8 percentage points below the three-month yield, the widest gap since December 2000 in what Duke University’s Campbell Harvey says is the most reliable indicator of a recession.
“Especially after the global financial crisis [of 2008-09] people said we just can’t ignore it anymore,” says Prof. Harvey. “So that [inverted curve] affects expectations.”
If you listen to the economists, things are pretty bad. Bad economic news means recession, of course, but so does good news. “It just means central banks have to do more,” says Alex Brazier, deputy head of the Investment Institute at fund giant BlackRock. “If the Fed wants to take core inflation all the way down [to its 2% target] it needs a recession.”
Economists could be wrong again. The comparison to the 1970s isn’t perfect, as the pandemic-driven lockdown and reopening led to rapid changes in the economy. Likewise, the yield curve isn’t magic, as the inversion reflects investor expectations that the Fed will cut rates again starting next year as inflationary pressures ease. And not every economist agrees that a recession is inevitable.
“Key data, especially market data, is looking anything but recessionary,” says Jan Hatzius, chief economist at Goldman Sachs. He points to the strong labor market, which is supporting household incomes, especially as headline inflation is expected to fall next year. Goldman puts the recession risk at 35%, well below the consensus.
Should investors worry if a recession hits? Historically, recessions have been accompanied by sharp falls in stock prices and bond yields. But since the S&P 500 hit its year-to-date low six weeks ago, shares are up 17%, even as Wall Street analysts cut their earnings forecasts for next year by about 3%.
Stocks are moving inversely with bond yields at the moment, a sign that investors are much more concerned about the interest rate outlook than earnings. That’s partly because the decline in projected earnings remains limited. (Analysts are as bad at predicting recessions as economists.) The rally was driven by a optimistic scenario of inflation falling without the Fed squeezing the life out of the economy, allowing interest rates to be cut later next year .
Such a soft landing is possible. But even in this scenario, bullish investors must also believe that Fed policymakers will quickly lose their inflation fears and realize sometime next year that rates can be cut.
Investors deciding whether to buy the stock and bond rally need three things to run right. First, inflation will fall on its own, not because demand collapses. Second, the Fed recognizes in good time that it does not need to curb demand to bring inflation back on target. Third, the sharp rise in interest rates that has already occurred is not leading to a recession, or a recession is so shallow that the gains are basically okay.
I have little faith in economic models that have missed so many recessions in the past. But it’s also hard to believe that stocks are experiencing anything other than a bear market rally.
Looking at the markets, money managers are moving their money in ways that suggest they see a recession coming. WSJ’s Dion Rabouin explains what to look for and why they tell us that investors are increasingly pricing in a recession. Illustration: David Fang
Write to James Mackintosh at [email protected]
Copyright ©2022 Dow Jones & Company, Inc. All rights reserved. 87990cbe856818d5eddac44c7b1cdeb8