The stock market is collapsing because investors now fear recession more than inflation

The stock market paradox, in which bad news about the economy is seen as good news for stocks, may have come to an end. If that’s the case, investors should expect bad news to be bad news for stocks heading into the new year — and there could be a lot of it.

But first, why is good news bad news? Investors spent 2022 largely focused on the Federal Reserve and its series of large interest rate hikes aimed at moderating inflation. Economic news that growth is slowing and there is little fuel for inflation could lift stocks on the idea that the Fed may start slowing down the pace of future cuts or even start making interest rate cuts in the future.

Conversely, good news for the economy may be bad news for stocks.

So what has changed? Last week saw a weaker than expected CPI reading for November. While it’s still very hot, with prices up more than 7% year-over-year, investors are increasingly confident that inflation likely peaked at a nearly four-decade high above 9% in June.

We see: Why November CPI data is seen as a ‘game-changer’ for financial markets

But the Fed and other major central banks have signaled they intend to continue raising interest rates, albeit at a slower pace, through 2023 and are likely to keep them higher for longer than investors expected. This fuels fears that a recession is becoming more likely.

Meanwhile, markets are acting as if the worst of inflation fears is in the rearview mirror, with recession fears now looming large, said Jim Beard, chief investment officer at financial advisory firm Blunt Moran.

That sentiment was bolstered by Wednesday’s manufacturing data and a weaker-than-expected retail sales reading on Thursday, Beard said in a phone interview.

Markets are “probably heading into a period where bad news is bad news not because prices will spook investors, but because earnings growth will falter,” Baird said.

“Reverse Tepper Circulation”

Keith Lerner, Truist’s chief investment officer, has argued that a mirror image of the backstory that produced what has come to be known as the “Tepper trade”, inspired by hedge fund tycoon David Tepper in September 2010, may be forming.

Unfortunately, while it was Tepper’s prescient call for a “win/win scenario.” Lerner said in a note on Friday that the “reverse Tepper trade” is shaping up as a loss/loss bid.

Tepper’s argument was that the economy would either get better, which would be positive for stocks and asset prices. Or the economy could weaken, with the Fed stepping in to support the market, which would also be positive for asset prices.

Lerner said the current setup is one in which the economy will weaken, curbing inflation, but also affecting corporate earnings and challenging asset prices. Or, alternatively, the economy remains strong, along with inflation, as the Fed and other central banks continue to tighten policy and challenge asset prices.

Either way, there are potential headwinds for investors. To be fair, there is a third path, where inflation goes down, and the economy avoids recession, which is called a soft landing. “It is possible,” Lerner wrote, but noted that the path to a soft landing is looking increasingly narrow.

Recession fears surfaced on Thursday, when retail sales for November showed a 0.6% decline, beating expectations for a 0.3% decline and the largest drop in almost a year. Also, the Philadelphia Fed’s manufacturing index rose, but remained in negative territory, disappointing expectations, while the New York Fed’s Empire State Index declined.

Stocks, which had taken moderate losses after the Fed raised interest rates the day before, fell sharply by half a percentage point. Stocks extended their decline on Friday, with the S&P 500 SPX,
posting a weekly loss of 2.1%, while the Dow Jones Industrial Average,
fell 1.7% and the Nasdaq Composite,
decreased by 2.7%.

Read: Still a bear market: S&P 500 indicates stocks never reached ‘escape velocity’

“As we move into 2023, economic data will become more of an impact on stocks because the data will tell us the answer to a very important question: How bad is the economic slowdown? (More hikes to start 2023), the key now is growth, potential damage from slower growth,” Tom Esay, founder of Sevens Research Report, said in a note Friday.

Slack control

No one can say for sure a recession will happen in 2023, Plant Moran-Bird said, but there seems no doubt that corporate earnings will come under pressure, and that will be a major driver for the markets. This means that earnings are likely to be a significant source of volatility in the coming year.

“If the story in 2022 is inflation and rates, then it will be earnings and recessionary risk in 2023,” he said.

It is no longer an environment that favors high-growth, high-risk equities, while cyclical factors can well be established for value-oriented and small-cap stocks, he said.

Until the guide weight changes, “we maintain our overweight in fixed income, where we focus on high-quality bonds, and relatively underweight in equities,” Trost’s Lerner said.

Within equities, US Trust favors any propensity for value, and sees “better opportunities below the surface of the market,” such as the S&P 500, which is a proxy for average stocks.

Highlights of the economic calendar for the coming week include a revised look at third-quarter GDP on Thursday, along with November’s index of leading economic indicators. On Friday, personal consumption and spending data for November, including the Fed’s preferred measure of inflation, is due for release.

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