Mike Wilson: Preparing for Potential Recession

Some investors think a potential recession is already priced in but given defensive leadership, labor statistics and incoming Fed rate hikes, it may be too early to tell.

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Welcome to Thoughts on the Market. I'm Mike Wilson, Chief Investment Officer and Chief U.S. Equity Strategist for Morgan Stanley. Along with my colleagues, bringing you a variety of perspectives, I'll be talking about the latest trends in the financial marketplace. It's Monday, July 18th, at 11 a.m. in New York. So let's get after it.

Last week, we highlighted how extreme the 12-month price momentum weightings are for defensive sectors. In fact, it's unprecedented for this type of price momentum to occur outside of an economic recession. One reaction to this development we've heard from many clients is that a recession must already be priced based on this relationship. If true, then defensive leadership is likely to reverse with something else taking the lead, like growth stocks or even cyclicals. We disagree and believe defensive leadership will likely persist until either a recession is officially announced, or the risk of a recession is definitively extinguished.

In our view, the first outcome can only be achieved with a series of negative payroll data releases, something that still seems far away given last month's 372,000 new job additions. The second outcome—a soft landing—will also be hard to prove to the market until earnings revisions bottom out and companies stop doing hiring freezes.

With respect to the recession outcome, the odds have been steadily increasing now for months. Morgan Stanley's proprietary economic model is currently suggesting a 36% probability of a recession in the next 12 months. Historically speaking, once it reaches 40%, it's usually a definitive reading that recession is oncoming. Furthermore, jobless claims have been rising the past few weeks. Secondarily, the household survey for total employment peaked in March and has fallen by approximately 400,000 jobs so far. While not the gold standard for measuring labor market health, it's worth watching closely as things can change rapidly for hiring and firing, particularly when profits come under significant pressure, as we expect. Finally, the job openings data has started to roll over, albeit from record high levels, while consumer and business confidence readings remain at record lows.

In the very near term, equity markets seem to be digesting another hot Consumer Price Index release very well, even as concerns rose that the Fed might raise rates as much as 100 basis points next week. Our view is that 75 basis points is still the base case, and that should be plenty to keep the Fed on track to getting ahead of the curve. Importantly, the bond market seems to agree with the yield curve inverting the most since the 2000 cycle, quickly catching up to the defensive leadership of the stock market. The bullish take which this market seems to want to try and run with one more time, is that the Fed can pivot before a recession arrives.

The other positive that has investors excited again is the fact that bank stocks had a strong rally on Friday, even as the earnings results were quite mixed. While this kind of price action is a necessary condition for the bear market to be over, we would caution that second quarter results are likely to be the first of several cuts, not just for banks, but for the market overall.

The bottom line is that this earnings season is likely to be the first of several disappointing ones, especially if a recession is the endgame. Therefore, staying defensively oriented in one's equity positioning should remain the best course of action for the next several months.

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