Stocks haven’t priced in an imminent recession. That could increase the risk of recession

By Isabel Wang

Risky asset valuations are well above recessionary levels and earnings are skewed to the downside next year, strategists say

A tightening of financial conditions is keeping recession risk high, but financial markets haven’t priced in an imminent recession, as risky asset valuations are still well above recessionary levels, said strategists at Goldman Sachs.

A team of strategists led by Christian Mueller-Glissmann, head of asset-allocation research, forecasts a 39% probability of a U.S. economic slowdown in 2023, but after the recent relief rallies in the stock market, they think risky assets are pricing only an 11% chance of an imminent recession, which increases the risk of further recession scares next year. (See chart below.)

Hopes that the Federal Reserve may pull back from its aggressive interest-rate-hike policy have lifted U.S. stocks in the past two months as inflation finally shows signs of cooling. The S&P 500 has gained 5.5% in November, while the Dow Jones Industrial Average has booked a monthly rally of 8.7% and the Nasdaq Composite has risen 1.6%, according to Dow Jones Market Data.

Goldman strategists see a low equity-risk premium considering elevated recession risk and uncertainty on the growth/inflation mix. A low premium usually indicates that the equity investment compensates investors little for taking on the higher risk of investing.

“Weak growth and volatility coupled with relatively high valuations keeps equity drawdown risk elevated,” the strategists wrote in a Monday note. “Financial stability concerns have also picked up alongside market stress indicators.”

Also read:Stock market could see ‘fireworks’ through the end of the year as headwinds have ‘flipped,’ Fundstrat’s Tom Lee says

Mueller-Glissmann and his team suggest investors remain “defensive in the next three months,” which means having more exposure to cash and credit, while neutralizing commodities and underweighting bonds and stocks.

“In the near term bonds and duration may continue to be a source of risk rather than safety in the portfolio as investors still need to reprice a ‘higher for longer’ rates regime,” said strategists. “We see potential for bonds to be less positively correlated with equities later in 2023 and provide more diversification benefits — but until central banks stop hiking and inflation normalizes further, they are unlikely to be a reliable buffer for risky assets.”

St. Louis Fed President James Bullard said in a MarketWatch interview on Monday that he favors more aggressive interest-rate hikes to contain inflation, and added that rates may need to stay elevated until 2024.

Meanwhile, John Williams, president of the New York Fed, said in a virtual event that further tightening is needed to cool inflation, which remains “far too high.”

MarketWatch Live:Stocks lose ground as China protests rattle markets

U.S. stocks extended losses on Tuesday after booking the worst day in nearly three weeks in the previous session as protests against China’s zero-COVID policy weighed on markets. The S&P 500 was down 0.1%, while the Dow lost 0.2% and the Nasdaq shed less than 0.1%.

-Isabel Wang

(END) Dow Jones Newswires

11-29-22 0956ET