A Recession May Be Coming. Buy Stocks Anyway.

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With recession worries mounting, it may be time for investors to load up on
stocks.
Yes, you read that correctly. 

Wall Street has been fretting over a looming recession for much of the last year after the Federal Reserve embarked on its rapid rate-rising path to ease inflation that was running at multi-decade highs. But while parts of the economy feel the sting of a slowing economy–the tech industry has laid off thousands of workers this year–many on Wall Street have come to believe that even if a recession materializes, it might not be as bad as some fear. With recession worries largely baked into the market–barring a sudden shock to the economy–it makes sense for investors to reintroduce riskier assets into their portfolios.

“Recession, shmecession,” Savita Subramanian, equity and quant strategist at BofA Securities, wrote in a note Monday in which she proposed investors own stocks over bonds and cyclical stocks over defensive names. Hedge funds and long-only funds are close to peak exposure in defensive industries such as health care, utilities, and consumer staples, meaning that there is likely a better risk-reward payoff for cyclical names.

That pay-off is even evident as the
S&P 500,
currently trading at 20 times forward earnings, appears expensive. But if earnings can stay steady at $50 per share over the next three quarters, the seemingly high multiple could be dismissed as a “trough multiple,” writes Nicholas Colas, co-founder of DataTrek Research.

“This time around, recession chatter is already everywhere and therefore at least somewhat baked into asset prices,” Colas wrote.

Neither Colas or Subramanian dismiss the possibility of a slowdown but they acknowledge that the Fed, after raising the federal funds rate from near-zero to a range of 4.75% to 5%, has more leeway to mitigate a downturn. So far the economy has chugged along with a few isolated disruptions over the last year, such as the collapse of Silicon Valley Bank and
Signature Bank
in March.

“Even if a recession is imminent, the Fed has latitude to soften the impact after pushing rates up by 5%. And after the fastest hiking cycle ever, the only thing to ‘break’ so far is SVB,” Subramanian wrote.

Subramanian and Colas aren’t alone in their optimistic thinking. Some corners of Wall Street are feeling confident that there will be no recession and that the very things that make a recession appear likely–the inverted yield curve, inflation, and the recent banking crisis–actually guarantee that one won’t happen. 

The inverted yield curve, which occurs when longer-term bonds have lower yields than short-term debt, has historically been a predictor of a recession, but it’s no longer a good barometer, writes Anatole Kaletsky, chief economist at Gavekal Research. This is because of changes in the market structure that mean that bond yields aren’t set so much by long-term bond investors but by quants and other more speculative market participants.

“As a result, changes in bond yields no longer anticipate economic prospects or inflation. Instead, bond yields just reflect expectations about Fed policy. And Fed policy, in turn, reflects bond yields,” Kaletsky said.

As for declining inflation, Kaletsky sees it more as evidence of improving supply chains rather than tightening monetary conditions. Kaletsky also brushes off notions that the recent banking crisis is signs of recession coming, noting that it will force the Fed to stop “single-mindedly pursuing its inflation target” and eventually pause its monetary tightening, thereby avoiding pushing the economy into a recession.

All of this should be good news for investors who have been nervous about having money in the market during challenging times.

One test for investors comes on Thursday when gross domestic product data for the first quarter is released, Wall Street expects that the economy will show 2% growth following growth of 3.2% and 2.6% in the third and fourth quarters of 2022, respectively. But the Atlanta Fed’s GDPNow model predicts 2.5% growth in the quarter. An upside surprise may temporarily spook the market, but it may actually end up better long-term.

“There is a good chance that the Q1 GDP report will surprise to the upside on Thursday. At the margin, this may be bad news for markets given hopes for Fed rate cuts later in 2023,” Colas wrote Monday.

If true, investors may want to start looking past a recession.

Write to Carleton English at [email protected]

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