Financial markets are issuing a warning that a recession is imminent: here’s what it means for equities

For most of this year, falling Treasury yields coincided with rising equity valuations as borrowing costs became a major concern for markets.

Today, it appears that this dynamic is changing, a sign that investors are beginning to prepare for an impending recession, although the equity market has not fully accepted this view.

“Copper prices are down, oil prices are down despite the inventory report being lower than expected and China reopening. The recession is weighing on everything,” said Gene Goldman, Chief Financial Officer. investments at Cetera Investment Management.

Crude oil prices traded in the United States CL00,
+0.31%
have fallen 10.5% so far this week to $71.59 a barrel, according to FactSet data. And although copper prices have risen slightly during this period, they are still down more than 13% so far this year. The yield on the 10-year Treasury note has fallen about 25 basis points since the beginning of December.

So far this week, the S&P 500 has fallen 2.8% after staging a torrid rally that began in mid-October. Sharp but short-lived rallies are not uncommon during bear markets, said Steve Sosnick, chief investment strategist at Interactive Brokers.

So far, stocks have remained surprisingly buoyant, although expectations for corporate earnings growth in 2023 have moderated.

In June, stock analysts had forecast earnings growth of 10.3% in 2023, according to FactSet’s average estimate. As of December 7, expectations had fallen to just 5.9%. And some on Wall Street, including Morgan Stanley’s Michael Wilson, expect earnings to contract in 2023.

But in the bond market, falling yields on longer-dated bonds, coupled with an increasingly inverted Treasury yield curve, send a pretty strong signal that markets are banking on a recession next year.

“Expectations of a recession are firming up and rightly so. We’re starting to see its price in the markets, which isn’t that surprising after the rally we’ve had over the past month,” said Jake Jolly, senior investment strategist at BNY Mellon Investment Management.

There’s an old adage on Wall Street that the bond market is a more reliable guide to what’s in store for the US economy.

“When stocks and bonds disagree on the economy, I tend to trust bonds more,” Sosnick said.

If this holds true again, it would mean stocks are likely down.

“If you look at the S&P 500 at 3,930, that effectively means next year’s earnings won’t fall. But in a recession earnings typically fall 10-15%,” said Ron Temple, chief US stocks at Lazard Asset Management.

So far, at least, the US economy appears to be holding up well despite the Federal Reserve raising its key interest rate by about four percentage points this year.

The US labor market added 263,000 jobs in November, while US gross domestic product rose 2.9% in the third quarter. Even the ISM barometer of activity in the services sector published at the beginning of the week was above 55%, a level that indicates growth.

More problematic for the Federal Reserve is the fact that wages rose in the year through November to 5.1% from 4.9% the previous month. Investors fear that inflation will continue to rise if the economy does not cool.

If the economy and inflation hold up, many on Wall Street expect the Fed to raise interest rates further, tipping the economy into a recession.

Fed funds futures markets on Thursday expect the Fed’s benchmark key rate to peak in March or May between 4.75% and 5.25%, before the Fed begins cutting rates before the end of the month. year, according to CME’s FedWatch tool.

This implies that markets expect a sharp downturn to begin sometime before the middle of next year, Temple said. If this happens, it is likely that the actions will be even more painful.

US stocks rallied on Thursday, with the S&P 500 gaining 0.7% to 3,961, while the Dow Jones Industrial Average DJIA,
+0.55%
gained 133 points, or 0.4%, to 33,732. The Nasdaq Composite COMP,
+1.13%
gained 1.2% to 11,085.