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It was not long ago that investors were consumed with fears of a coming U.S. recession, spooked by an inverted Treasury yield curve, estimates of declining corporate profits, and waning business investment due to the trade war with China.
The nadir for market sentiment was Oct. 1, when the Institute for Supply Management’s (ISM) survey of manufacturers showed the sector contracted in September at its fastest pace since the Great Recession of 2008, while the growth of the services sector also slowed at a worrying pace.
Since early October, however, sentiment has made a surprising recovery, fueled by easy Federal Reserve monetary policy, better-than-expected third-quarter corporate earnings, and global economic data that many say has bottomed out and is poised to rebound. Questions remain though as to whether the market is are getting ahead of itself and are now ignoring lingering signs that a recession may still be on its way next year, analysts say.
“The disconnect between the economic data and what is discounted in the S&P 500 continues to grow,” wrote Lisa Shalett, chief investment officer at Morgan Stanley Wealth Management, in a Monday note to clients. “The consensus view [is that] deterioration in economic indicators bottomed in September,” she added. “Since then however, the data have not been encouraging.”
Since Oct. 1 the S&P 500 index SPX, +0.23% has gained 6.6%, the Dow Jones Industrial DJIA, +0.18% as risen 5.6% and the Nasdaq Composite index COMP, +0.30% has advanced 9.3%.
Shalett pointed to a contraction in US industrial production in October, a disappointing reading of the New York Fed regional manufacturing survey, and Morgan Stanley’s estimate that the Institute for Supply Management’s (ISM) estimate of manufacturing activity in November will show further negative growth, as reasons for concern.
“The bulls dismiss the manufacturing recession as old news that doesn’t matter,” Shalett wrote.
“However, we believe that they are ignoring that not only is the data deteriorating, but that it is surprising to the downside—a combo that the market has historically not liked,” adding that the Citi U.S. Economic Surprise index fell below zero in the second half of November, indicating that economic data has largely been surprising to the downside.
Morgan Stanley Wealth Management On the other hand, bulls can take solace in Markit’s survey of manufacturing health which surprised to the upside in November and showed the sector growing, according to Tom Essaye, president of the Sevens Report, in a Monday note. But Essaye also pointed to a potentially worrying sign out of last week’s data: first-time claims for jobless benefits remained at a five-month high in the week ended Nov. 16.
“Considering that recession fears are based on a slowdown in manufacturing and business spending bleeding into the labor market and, ultimately, the consumer, it’s notable that claims are rising,” he warned.
Meanwhile, Essaye added, the yield curve, or the spread between yields on government bonds of differing maturities, continues to flatten, a sign that fixed-income investors are potentially concerned about future economic growth.
“Since last week, the yield curve has broken its multi-month uptrend and begun to compress, relatively rapidly, amid trade war developments,” he wrote, adding that the difference between the yield on the 10-year U.S. Treasury note TMUBMUSD10Y, -0.88% and the 2-year U.S. Treasury note TMUBMUSD02Y, -1.20% has fallen to a six-week low. “Looking ahead, the fact that the trend line has broken is not a bearish game changer in and of itself, but it is a notable warning sign.”
Read more: 5 things investors need to know about an inverted yield curve
Jeffrey Schulze, puts the chances of a recession in 2020 at 50%, based in large part on the inversion of the yield curve earlier this year and the sharp slowdown in manufacturing. His firm’s “recession risk dashboard” is now flashing yellow — indicating a heightened risk for a recession.
He said that despite rising risks, the Fed’s decision to cut interest rates three times this year could provide reason for optimism.
“There’s been three instances where the dashboard has turned yellow, but economic growth reaccelerated and went back to green: 1995, 1998 and 2016,” he said. “We think all three of those would have been a recession, but the Fed recognized weakness and the provided liquidity to the economy and it reaccelerated from there.”
Furthermore, Schulze predicts that if the U.S. economy does tip into a recession next year, it will not be a severe one. “The past two recessions were caused by a historic real estate bubble and one of the largest stock-market bubbles in history,” he said, adding that this has caused investors to think of recessions as severe outcomes that will necessarily lead to multiyear bear markets.
A better comparison would be the 1990-1991 recession, which led to just a 0.2% decline in GDP in nominal terms, versus the 3.3% decline following the Great Financial Crisis. A recession of this magnitude may not be of much concern to buy-and-hold investors, as it lead to a market decline of roughly 20% between July of 1990 and October of 1990, losses that were regained by February of 1991.
