Wall Street still wondering if recession is in the cards

Earlier this year, many investors thought the U.S. economy would be falling into a recession by now, the Federal Reserve would have to start cutting interest rates and a strong economic recovery for China would provide a cushion for the global economy.

None of those things has happened. In the meantime, the U.S. stock market has rallied roughly 14% to touch its highest level since April 2022.

As Wall Street looks toward the back half of 2023 and beyond, it’s stuck in a sort of purgatory. Many investors are still preparing for an upcoming recession, but they keep pushing out their predictions by another few months. Until more clarity arrives on whether a downturn will indeed arrive, markets could be in for a shaky path.

Here’s a look at the arguments for the upside and downside.

Stocks can keep going

Despite piles of predictions for a recession, the U.S. economy keeps chugging along. The job market has remained remarkably solid, helping consumers feel confident and willing to spend. That’s offset weakness in such industries as banking and manufacturing caused by high interest rates.

The Federal Reserve has hiked interest rates at a blistering pace to slow the economy in order to undercut high inflation. But the end of those hikes appears to be nearing as inflation has slowed since last summer. The Fed has suggested only one or two more increases may be on the way this year.

An economy that avoids a recession would support corporate profits, which are the lifeblood of the stock market. It could also broaden out the market’s gains.

A big concern this year has been how much of the S&P 500’s rise is tied to a handful of big stocks, particularly those benefiting from the artificial-intelligence boom. So far this year, the biggest 15 companies in the S&P 500 have gone up 34%, while the median company is up just 1%, according to Goldman Sachs.

Some broadening out may have already begun, with the smallest stocks in the Russell 2000 index up more than the S&P 500 through the first four weeks of June.

Plus, more money is sitting on the sidelines in cash that could get invested, which offers potential fuel for the stock market. Nearly US$2 trillion is in retail money-market funds held by the general public, not including US$3.44 trillion more held by institutions. That’s up 11% in just four months, according to the Investment Company Institute.

Stocks are in trouble

Yes, the economy has avoided a recession because of a strong job market. But that’s often one of the last things to crack under the pressure of higher rates.

A pattern usually occurs in such cycles: In the last nine rate-hike campaigns by the Fed, seven have resulted in a recession, according to Darrell Cronk, president of Wells Fargo Investment Institute. He’s still expecting a downturn to hit in the second half of 2023 or early 2024, even if it’s “the most predicted and longest anticipated recession in recent memory.”

Even if the Fed soon stops hiking rates, it has pledged to keep them high to drive inflation down to its 2% goal. That could take a while with inflation still 4% last month, as measured by the consumer price index, and it’s hard for investors to predict what might break if rates remain high for a long period of time.

The Fed has pulled its benchmark rate up by a mammoth 5 percentage points from virtually zero at the start of last year, which has already helped cause several U.S. bank failures.

“There is a path higher for stocks, but it is a narrow one and comes with risks: Economic growth can neither be so strong as to force the Federal Reserve into further hikes, nor so weak as to drive fears of a recession,” according to strategists at UBS.

If the Fed can’t manage its narrow path, a recession could pull profits sharply lower. That would hit stocks doubly hard because critics say they already look pricey compared with how much profit companies are producing.

A drop in profits is one reason Morgan Stanley Wealth Management says the S&P 500 could be lower in mid-2024 than it is now in its base case scenario.

Either way, at least yields are higher

Whether stocks go up or down, investors can take some solace in that bonds are paying more in interest than a year ago.

That could provide more income and more protection for those who hold a mixed set of stocks and bonds in their portfolios, as many experts recommend. A 10-year Treasury recently offered a yield of 3.76%, up from roughly 1.50% at the start of last year.