The likelihood of a “hard landing” for the U.S. economy jumped as equity and bond investors worried about slowing economic growth, according to Morgan Stanley’s wealth management division.
“The stock and bond market downturn has evolved into behavior resembling a classic cyclical bear market rather than a simple correction,” Lisa Shalett, chief investment officer at Morgan Stanley Wealth Management, said Monday.
“With Federal Reserve policy still poised to pick up the pace of tightening, with balance sheet shrinking entering the mix and inflation proving somewhat stubborn,” she wrote, “investors are turning their gaze to the potential for a fear of growth, or even an outright recession.”
Morgan Stanley sees a 27% probability of a recession over the next 12 months, with the probability dropping from just 5% in March, according to the note. Shalett said the Institute for Supply Management’s manufacturing PMI, an indicator of U.S. factories, “also signals concern” as it shows growth is slowing.
Stocks and bonds have suffered this year as the Fed seeks to fight inflation by raising interest rates. “A portfolio of equal parts stocks and bonds would have fallen more than 10% in the past six months, the worst experience since the financial crisis,” Shalett wrote. “With the fight against inflation now serious and the Fed’s policy regime turned hawkish, the rise in interest rates has been punitive.”
Major U.S. stock indexes ended mixed on Monday amid concerns over global economic growth, with the Dow Jones Industrial Average DJIA,
registering a gain of 0.1%, the S&P 500 SPX,
down 0.4% and the Nasdaq Composite COMP,
down 1.2%, according to FactSet data. The Federal Reserve Bank of New York said on Monday its Empire State Business Conditions Index, an indicator of manufacturing activity in the state, plunged 36.2 points to -11.6 in May.
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The market is “trying to decide if the Fed will be able to stage a soft landing, or if the Fed is trying to thread too small a needle and heading for a policy error,” said Ed Clissold, chief U.S. strategist at Ned Davis Research, in a telephone interview on Monday. The Fed aims to rein in runaway inflation by raising rates without causing a recession or achieving a so-called soft landing.
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Clissold said that over the next few weeks the market will likely continue to experience high volatility while “testing” recent lows to gauge how “exhausted” selling might be.
The S&P 500 is currently in correction territory, having fallen nearly 16% this year, while the tech-heavy Nasdaq Composite is in a bear market, having fallen more than 25% so far in 2022, according to FactSet data. A correction is defined as a drop of at least 10% from a recent high, while a bear market has entered after a 20% drop.
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“As the market narrative turns to the possibility of a recession, investors should once again seek out bonds to protect their portfolios,” she said. “Diversification is not dead.”
Ned Davis’ Clissold told MarketWatch that he is underweight equities, overweight cash and has “market weight” bonds. Ned Davis switched to “market weighting” bonds a few weeks ago from an underweight in the hope that investors’ attention on inflation fears would start to shift to the “growth fears,” he said.
In an environment resembling a cyclical bear market, “the negative catalysts are not just higher rates and lower valuation multiples, but a true reversal in earnings growth momentum,” according to Shalett’s note. “During this phase, balance sheet strength and credit markets come under greater scrutiny,” she wrote.
Hunter Hayes, a portfolio manager at Intrepid Capital that invests primarily in high-yield corporate bonds, said in a phone interview Monday that over the past two months he has added debt positions in the provider Ezcorp Inc. EZPW Pawnbroker,
and Turning Point Brands Inc. TPB,
in the hope that these companies should hold up well in the event of an economic downturn.
Turning Point’s consumer products include Stoker’s chewing tobacco, Hayes said, adding that “vice products” tend to be “recession-proof.”
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“The first quarter earnings season was strong in almost every way, but based on recent market behavior, it’s evident that in general market participants have been paying little attention,” Jeff wrote. Buchbinder, equity strategist for LPL Financial, in an emailed note on Monday. “This is a macro market, so it will likely take some positive macro developments, i.e. better news on the inflation front, to get equities right.”
Meanwhile, Morgan Stanley’s U.S. economics team just cut its forecast for full-year gross domestic product growth by 100 basis points to 2.6%, according to Shalett’s memo.
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Although aiming for a soft landing, the Fed is under pressure to accelerate the pace of monetary tightening to rein in inflation which “shows little sign of abating,” she wrote. “It’s increasingly problematic,” she said, pointing to “complicating factors” such as the Russian-Ukrainian war and COVID-19 lockdowns in China.
“On balance, this suggests global growth may be slowing faster than expected,” Shalett warned.