The stock market is sliding because investors fear recession more than inflation

A paradox in the stock market, where bad news about the economy is considered good news for stocks, can run. If so, investors should expect bad news to be bad news for stocks heading into the new year – and there may be a lot of it.

But first, why should good news be bad news? Investors spent 2022 largely focused on the Federal Reserve and its rapid series of large rate hikes aimed at bringing inflation to heel. Economic news showing slower growth and less fuel for inflation could serve to lift stocks on the idea that the Fed might start slowing the pace or even start entertaining rate cuts in the future.

Conversely, good news about the economy could be bad news for stocks.

So what has changed? The past week saw a softer-than-expected November consumer price index reading. While they are still very hot, with prices rising more than 7% year on year, investors are increasingly confident that inflation is likely to reach a nearly four-decade high above 9% in June.

See: Why November’s CPI data is seen as a ‘game-changer’ for financial markets

But the Federal Reserve and other major central banks have indicated that they intend to continue raising rates, albeit at a slower pace, in 2023 and are likely to keep them elevated longer than investors anticipated. This is the fear that a recession is becoming more likely.

Meanwhile, markets are behaving as if the worst of the inflation scare is in the rearview mirror, with recession fears now looming on the horizon, said Jim Baird, chief investment officer of Plante Moran Financial Advisors.

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That sentiment was bolstered by manufacturing data on Wednesday and a weaker-than-expected retail sales reading on Thursday, Baird said, in a telephone interview.

Markets are “probably going back to a period where bad news is bad news not because rates will cause concern for investors, but because earnings growth will decline,” Baird said.

A ‘Reverse Tepper Trade’

Keith Lerner, co-chief investment officer at Truist, argued that a mirror image of the series that produced what became known as the “Tepper trade,” inspired by hedge fund titan David Tepper in September 2010, may form.

Unfortunately, while Tepper’s call for a “win/win scenario.” The “reverse Tepper trade” is shaping up as a lose/lose proposition, Lerner said, in a note Friday.

Tepper’s argument was that the economy was either going to get better, which would be positive for stocks and asset prices. Or, the economy would weaken, and the Fed enters to support the market, which would also be positive for asset prices.

The current configuration is one in which the economy will weaken, taming inflation, but also denting corporate profits and challenging asset prices, Lerner said. Or, instead, the economy remains strong, along with inflation, and the Fed and other central banks continue to tighten policy, and challenging asset prices.

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“In any case, there is a potential headwind for investors. To be fair, there is a third path, where inflation goes down, and the economy avoids recession, the so-called soft landing. It is possible,” Lerner wrote, but noted the path to a soft landing seems increasingly narrow.

Recession jitters were on display Thursday, when November retail sales showed a 0.6% drop, beating forecasts for a 0.3% decline and the biggest drop in nearly a year. Also, the Philadelphia Fed’s manufacturing index rose, but remained in negative territory, disappointing expectations, while the Empire State Fed New York index fell.

Read: Still a bear market: S&P 500 slide signals stocks never reach ‘escape velocity’

Stocks, which posted moderate losses after the Fed a day earlier raised interest rates by half a percentage point, fell sharply. Equities extended their decline Friday, with the S&P 500 SPX,
entered a weekly loss of 2.1%, while the Dow Jones Industrial Average DJIA,
shed 1.7% and the Nasdaq Composite COMP,
fell 2.7%.

“As we enter 2023, economic data will become more of an influence on actions because the data will tell us the answer to a very important question: How bad will the economic slowdown become? This is the key question during we are starting the new year, because with the Fed on relative ‘auto pilot’ policy (more increases to start 2023) the key now is growth, and the potential damage from slowing growth, “said Tom Essaye, the founder. Sevens Report Research, in a note on Friday.

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Recession watch

Plante Moran’s Baird says Plante Moran’s Baird said that no one can say with complete certainty that a recession will occur in 2023, but there seems to be no doubt that corporate earnings will come under pressure. And that means earnings have the potential to be a significant source of volatility in the coming year.

“If in 2022 the story was inflation and rates, for 2023 it will be wages and recession risk,” he said.

It’s not an environment that favors high-growth, high-risk stocks, while cyclical factors could set up well for value-oriented stocks and small caps, he said.

Lerner Truist said that until the weight of the evidence changes, “we keep our overweight in fixed income, where we focus on good quality bonds, with a relatively underweight in shares.”

In stocks, Truist favors the US, a value tilt, and sees “better opportunities below the surface of the market,” such as the equal-weighted S&P 500, a proxy for the average stock.

Highlights of the economic calendar for the coming week include a revised look at third-quarter gross domestic product on Thursday, as well as the November index of leading economic indicators. On Friday, November personal consumption and spending data, including the Fed’s preferred inflation gauge are set to be released.


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