There is a 90-per-cent chance of a U.S. recession ahead. So go ahead and buy stocks.
That is the rather counterintuitive message from Roberto Perli, a former Federal Reserve economist who now serves as head of global policy at investment bank Piper Sandler.
In a note Tuesday, he calculated that the odds of a U.S. recession by late 2023 are now as high as 90 per cent. Bond market indicators followed by two of his models with good track records of calling past recessions have turned unusually negative.
But despite what you might expect, Mr. Perli doesn’t view this gloomy economic message as a signal for investors to stampede out of stocks. Instead, he sees it as an opportunity.
“On average, across the past three recessions, the S&P 500 tends to appreciate in the quarters that precede recession,” Mr. Perli wrote.
This rather odd state of affairs occurs because the Fed usually starts to hike interest rates when it perceives the economy to be running too hot. The hot economy generates strong earnings, which are good for stocks, but also fuels inflation, which is bad for the economy in general.
During such patches, a volatile stock market struggles to balance the threat of higher interest rates in the future with the reality of strong earnings in the here and now. It typically edges higher – “albeit in a chippy fashion and with a defensive bent,” Mr. Perli writes – right up until higher rates push the economy over the recessionary edge.
Note the emphasis on “defensive bent.” The sectors that tend to do best in the year leading up to a recession are steady-eddy businesses such as utilities (up 36.6 per cent on average), tech (up 23.3 per cent) and real estate (up 15.3 per cent). The revenue of those sectors doesn’t move in line with the economic cycle, so they act as havens for investors worried about a recession ahead.
In contrast, sectors such as consumer staples (up 3.8 per cent), telecom (up 4.2 per cent) and financials (up 8.5 per cent) don’t fare nearly as well in the run-up to a downturn, according to Mr. Perli’s calculations.
His surprisingly upbeat short-term outlook for at least some stocks is not that far removed from how some other prominent observers view the situation. Robert Buckland, a global equity strategist at Citigroup, recently wrote that he sees a mild 5-per-cent gain for global shares over the remainder of 2022. His argument is that it is difficult to see stocks declining when bonds, their primary rival, are still paying considerably less than zero after accounting for the bite of inflation.
Other analysts also see reason to stay in stocks. Oliver Allen, a markets economist at Capital Economics, noted this week that the S&P 500 benchmark of large U.S. stocks rarely falls more than 10 per cent unless analysts have already slashed their earnings expectations.
The opposite is occurring now. Analysts have been busily boosting their earnings forecasts for the next few months. Their optimism suggests that U.S. stocks are still on solid footing, despite rising interest rates and war in Europe.
Investors may want to keep their hopes in check, though. Mr. Allen acknowledges that rising interest rates will eventually start to drag on share prices. He forecasts that the S&P 500 will end the year around 4,600, only a hair above its current level around 4,400.
For investors, this adds up to an interesting risk-versus-reward problem. The potential reward for taking on the risks of investing in the broad stock market appears underwhelming at a moment when interest rates are on the upswing and a possible recession looms on the horizon. However, bonds don’t offer an obvious short-term refuge from the risk since bond prices fall when interest rates rise.
One hope for stock market investors is that this time could turn out to be different. In most past recessions, inflationary pressures were clearly rising. Central banks hammered the inflationary surge by aggressively hiking interest rates, which then threw the economy into recession and kneecapped stocks.
The situation is not so clear-cut today. Granted, U.S. inflation hit 8.5 per cent in March, the highest level in four decades, according to figures published Tuesday, but that reading could tumble quickly if supply chains continue to untangle and oil prices fade back from recent highs.
If inflation does come down without drastic action from the Fed, the odds of a recession are much lower than they appear at the moment, Mr. Perli writes. For now, though, he suggests investors focus their attention on the sectors, such as utilities and tech, that have done well in the run-up to past recessions.
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Ian McGugan