Recession challenges inflation as top fear among stock and bond investors

It’s easy to want to duck for cover given the carnage seen this year in stocks and bonds, particularly with the Federal Reserve vowing to undertake a stalwart battle against high inflation.

While inflation, hitting its highest level in 40 years, remains near the top of many investors’ list of concerns, another potential problem for markets has begun to loom, in the form of slower growth in corporate earnings, and potentially in the broader US economy.

“I would say there is definitely a concern that earnings expectations are falling again. Smoothing out, but not falling off a cliff,” Jake Remley, senior portfolio manager at Income Research + Management, said by phone.

Ahead of new corporate results from mid-July, analysts pegged the SPX of the S&P 500 Index,
+3.06%
Estimated second-quarter earnings growth rate at 4.3%, according to a Friday report from FactSet, a level that would mark its lowest annual growth rate since the fourth quarter of 2020.

“You could argue that the bad news will take some pressure off the Fed,” Remley said, speaking of the Fed’s plans to drastically tighten financial conditions this summer, in an attempt to cool rampant inflation.

“They don’t want to break the consumer, or the corporate bond market, or bank balance sheets,” he said. “But it will take more than they have done, from our perspective,” to prevent high costs of living from taking hold.

“The faster they do it, the better.”

Recession or inflation?

It is a delicate dance. The Fed wants to cool demand for goods and services, through sharply higher interest rates, but without going too far, putting workers out of work and causing an economic recession.

San Francisco Fed President Mary Daly on Friday added her support for another Big rise in interest rates in July aim for high inflation, without derailing the economy.

“The biggest fear is not one or the other, it’s both,” Mark Heppenstall, chief investment officer at Penn Mutual Asset Management, said of whether a growth scare or inflation is more important.

The US economy shrank 1.4% on an annualized basis in the first quarter. With higher interest rates and tighter financial conditions, the economy could be headed for a technical recession, he said by phone.

“It definitely feels like a period of stagflationwhich is why we are seeing so much volatility in asset prices and interest rates.”

Stocks rose this week, with the S&P 500 SPX,
+3.06%
finishing 3.1% higher on Friday, to book your best day in over two years. But the broad market gauge was still down 17.9% for the year, in a bear market, with the Nasdaq COMP Composite Index,
+3.34%
off 25.8% so far in 2022, according to FactSet.

The first-class DJIA Dow Jones Industrial Average,
+2.68%
it was up 5.4% for the week but still down 13.3% year-to-date.

Read: Stagflation, reflation, soft landing or crash: what Wall Street expects in the second half of 2022

layoff tracking

A key component of 1970s-style stagflation was the combination of high inflation and a weak labor market. By comparison, the current the employment picture still looks pretty robustt.

However, that could change quickly if more companies start reporting disappointing corporate earnings, not just as a strong dollar cripples international salesbut more broadly of the domino effects of inflation at 8.6%its highest level in 40 years.

“The inflation rhetoric is cooling off, while the recession narrative is gaining headlines,” Bob Schwartz, senior economist at Oxford Economics, said in a note on Friday. “That turn in sentiment is sweeping through the financial markets.”

He also pointed to the decline in bond yields as a potential harbinger of an economic slowdown. The benchmark 10-year Treasury yield TMUBMUSD10Y,
3.135%
it was at 3.125% on Friday, well below the recent peak of 3.482% reached on June 14, according to Dow Jones Market Data.

“Layoffs are on the rise and job offers are being rescinded,” Schwartz said.

Layoffs are on the rise

oxford economics

While “job seekers have more than enough positions to choose from,” Schwartz said, he also echoed some concerns expressed this week. by Senator Elizabeth Warren during Fed Chairman Powell’s two-day testimony on Capitol Hill. Both noted that the labor market could weaken as a result of the central bank’s tactics to combat inflation.

In other words, the “strong bargaining position that workers have enjoyed in the last two years may be eroding.”

Among the key economic data available: Monday will bring pending home sales for May, followed by the April reading of the S&P Case-Shiller US home price index on Tuesday. Wednesday brings updated US GDP for the first quarter. Thursday has more inflation data for May.

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