Stock Market Could Crash Another 20% If U.S. Plunges Into Recession

As a growing number of investment banks and company chiefs warn that the likelihood of a recession is increasing, analysts at Morgan Stanley are telling clients that the stock market—despite reeling from a steep selloff in recent weeks—has plenty of room to fall before hitting levels consistent with recession-era lows, which would be especially bad for cyclical industries like travel and hospitality.

Despite major stock indexes plunging more than 20% below recent highs, markets are still only down by about 60% of the average drawdown compared with previous recessions (which denote two consecutive quarters of negative GDP growth), Morgan Stanley analysts told clients in a Tuesday note.

As the Federal Reserve works to combat decades-high inflation with interest rate hikes that will likely stunt economic growth, a recession “is no longer just a tail risk,” analysts led by Michael Wilson wrote, putting the odds of one over the next year at 35%, up from 20% in March.

They estimate the S&P 500 could plunge as much as 20% to 3,000 points, from current levels of 3,770, if the U.S. falls into recession, citing earnings that tend to fall an average of 14% during recessions—a marked turnaround from record profits and 25% growth last year.

“The bear market will not be over until recession arrives—or the risk of one is extinguished,” the analysts said, adding that market weakness will likely continue over the next three to six months in the face of “very stubborn” inflation readings.

With high prices deterring some consumer spending, Morgan Stanley says stocks tied to discretionary spending, like those in retail, hotels, restaurants and clothing, are at higher risk of a downturn, while those tied to the internet, payments and durable household goods (like appliances and computers) are less at risk.

The note comes the same day Tesla CEO Elon Musk said the U.S. economy will “more likely than not” face a recession in the near term, echoing concerns raised by several other top business leaders and financial institutions following last week’s steeper-than-expected hike in key interest rates, which tend to deter spending by making borrowing more expensive.

Morgan Stanley’s not alone in raising recession odds this week. In a note to clients Monday, Goldman Sachs’ chief economist, Jan Hatzius, said the firm now sees “recession risk as higher and more front-loaded,” given the Fed’s more aggressive rate hike, putting the odds of a recession over the next two years at 48%, up from 35% previously. The investment bank estimates tighter financial conditions could drag down GDP as much as 2 percentage points over the next year.

Restaurants are most at risk of a pullback in spending, according to a Morgan Stanley survey of some 2,000 consumers. Roughly 75% of respondents said they’ll cut back on dining out over the next six months, while 60% said they’d do so on deliveries and takeout from restaurants. Though driving much of the inflationary gains, essential items like gas and groceries should see more resilient spending, with roughly 40% of consumers saying they’d cut back on either.

Major stock indexes plunged into bear market territory last week ahead of the Fed’s largest interest rate hike in 28 years, and the gloomy sentiment has ushered in waves of layoffs among recently booming technology and real estate companies. “We don’t believe the Fed can stop the issues that are causing inflation on the supply side without absolutely wrecking the economy, but at this point, it looks like they are resigned to the fact that it must be done,” says Brett Ewing, chief market strategist of First Franklin Financial Services. Goldman Sachs has warned clients it expects another 75-basis-point hike in July.

Jonathan Ponciano

I’m a senior reporter at Forbes focusing on markets and finance. I graduated from the University of North Carolina at Chapel Hill

Source: Stock Market Could Crash Another 20% If U.S. Plunges Into Recession—These Industries Are Most At Risk

The best hope for stocks right now is a recession that crushes inflation and allows the Fed to slow, stop or even reverse rate hikes.

Why it matters: Down 20.5% so far in 2022, it’s the ugliest year for the S&P since 1962. The drop vaporized $9 trillion in paper wealth, delivering a psychological shock to millions whose retirement is mostly in stocks.

Driving the news: Facing persistent inflation, the Fed delivered its largest rate hike since 1994 on Wednesday.

The increase is the monetary-policy equivalent of stomping on the country’s economic brakes — sharply increasing the risk that growth contracts.
Despite the recent beating shares have taken, the Fed’s announcement was greeted with open arms by investors. The S&P 500 rose 1.5%. The Nasdaq rose 2.5%. Interestingly, the Russell 2000 — which is more closely tied to short-term ups and downs of the economy — rose less, at just 1.4%.

The big picture: A huge rate hike that raises the risk of recession may sound like a bad thing for stocks — but with inflation still rising, it isn’t.

Essentially, investors are saying they prefer a big, sharp Fed-induced economic shock now if it quickly gets inflation under control. In theory, that could allow lower rates to return after inflation is vanquished.
Low interest rates have been crucial to the performance of stocks over the last decade.

Context: While Americans have a habit of looking at the stock market as an economic indicator, the linkage between economic growth and stock market performance is surprisingly weak, and, some academics say, nonexistent. The most extreme example of this reality arose during the bleakest moments of the COVID-related recession.

In April 2020, the U.S. economy was essentially on life support. Unemployment that month was 14.7%. There were, quite literally, bread lines miles long.
That month the S&P 500 posted its best month in 33 years, rising nearly 13%.

What gives? Well, in late March 2020, the Federal Reserve had to cut interest rates to zero and restart money-printing programs do deal with the COVID crisis. (The Federal government also began dumping what would ultimately be trillions of dollars into the economy to keep people afloat.)

The intrigue: But don’t recessions hurt corporate earnings? Wouldn’t that make stocks fall?

Earnings are one ingredient in stock prices, and they can definitely fall during recessions. But recently, interest rates — essentially the yield on the 10-year Treasury note — have played a more important role in establishing stock prices than earnings.
That’s because those interest rates largely determine the valuation multiple — otherwise known as a price-to-earnings ratio — investors use to determine the price they’re willing to pay for those future earnings (effectively, the price of a stock).
TL;DR: Higher rates = lower valuations, and vice versa.
So, even if earnings are expected to fall, stock prices can still rise, if valuations rise enough. Those valuations are largely determined by interest rates — and those rates are largely determined by Fed decisions.

The Federal Reserve made an aggressive new move in its campaign to bring down inflation Wednesday, raising its target interest rate by three-quarters of a percentage point, the steepest rate hike since 1994 — and indicated another similar move could be coming next month.

Driving the news: In addition to increasing their target for short-term interest rates to a range of between 1.5% and 1.75% Fed officials projected that their target rate will reach 3.4% late this year, far higher than the 1.9% they envisioned in March. Mortgages, car loans and credit card debt are all about to get more expensive.

Yields on U.S. government bonds — known as Treasuries — rocketed in recent days, as Friday’s inflation report convinced many that a combination of persistently high inflation and aggressive Federal Reserve interest hikes, is on the way. The yield on the 10-year Treasury note surged to nearly 3.50% in recent days, a level not seen since 2011……

Matt Phillips