Are the chances of a U.S. recession rising?

On the latest edition of Market Week in Review, Chief Investment Strategist for North America, Paul Eitelman, and Sophie Antal-Gilbert, Head of AIS Portfolio & Business Consulting, discussed recent market volatility, the U.S. recession outlook and third-quarter earnings season expectations.

Is bad news for the economy good news for markets?

Antal-Gilbert kicked off the conversation by noting that markets were volatile again the week of 3 October, with large gains at the start, followed by a downward dip in the middle. Eitelman attributed the reason for the swings to persistently high inflation, which has been a thorn in investors’ sides for months on end.

"Every time new numbers roll in, markets parse the data from all angles to see how it could influence the rate-hiking campaigns of central banks - and specifically, how much economic damage may need to be inflicted in order to bring inflation under control again," he explained.

This has led to an interesting environment for investors, Eitelman remarked - one where what’s bad news for Main Street is good news for Wall Street and vice versa. For instance, a report that shows economic growth is slowing will typically be treated as wonderful news by equity markets today, he said. As proof, Eitelman pointed to a recently released report from the Institute of Supply Management (ISM) regarding new orders in the U.S. manufacturing sector. "The report showed that new orders contracted pretty sharply during September, and following the publication of this report, equities staged a major rebound after selling off in droves the previous few weeks," he noted.

Eitelman added that this theme played out again later in the week of 3 October, but in reverse, with markets reacting negatively to good economic news. On 5 October, the ISM’s purchasing managers’ index (PMI) for the services sector came in at a level of 56.7 during August - ;well above the demarcation line between expansion and contraction, Eitelman said. "Overall, this report showed that the services sector is still growing at a pretty healthy clip - and while that’s good news for the economy, it was bad news for equity markets, which dipped in the wake of the numbers," he stated.

Ultimately, the bad-news-is-good-news/good-news-is-bad-news theme has dominated markets in recent days, Eitelman said, leading to a fair amount of choppiness as investors try to digest the impacts of a tighter monetary policy on inflation.

Will the Fed’s rate-hiking campaign trigger a U.S. recession?

Zeroing in on the potential for an economic downturn in the U.S. as the Federal Reserve (Fed) continues to aggressively raise rates, Eitelman said he believes recession risks are building due to inflation continuing to run hot - and at levels far beyond the Fed’s target range of 2%.

"With the latest U.S. CPI (consumer price index) numbers again surprising to the upside, and wage inflation remaining sticky and at very high levels, I believe it’s increasingly likely that the Fed will have to hike rates north of 4%," Eitelman said, noting that the central’s bank key rate currently sits in a range of 3.25%-3.50%.

In his opinion, this makes it more likely than not that the U.S. could slip into a recession at some point in the next 12 months - although Eitelman cautioned that nothing is for certain. He added that while talk of a potential recession may seem a bit scary, the issue is one that markets have been digesting for quite some time. "This is why markets are down pretty significantly this year, and why we’re seeing some significant signs of pessimism," Eitelman said. With a potential recession coming more into focus, he stressed the importance for investors of staying disciplined and sticking to their strategic asset allocations.

What’s the outlook for Q3 earnings season?

Antal-Gilbert and Eitelman concluded the segment with a look at U.S. third-quarter earnings season, which kicks off in earnest the week of 10 October, with several big banks reporting results. Eitelman said the upcoming earnings season will be a particularly interesting one to watch, given the backdrop of a slowing U.S. economy and some pretty acute cost pressures. "So far this year, U.S. earnings have been fairly resilient, but I think there’s a lot of question marks around how long businesses can maintain their profitability in this kind of an environment," he remarked.

Right now, consensus expectations are for 3% earnings growth during the third quarter for the S&P 500® Index, Eitelman said, which would be the lowest growth rate since the third quarter of 2020. "We’ll find out over the coming weeks whether that benchmark is hit or missed," he remarked, adding that there will also be plenty of attention focused on what management teams say about the outlooks for their companies moving forward.

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Any opinion expressed is that of Russell Investments, is not a statement of fact, is subject to change and does not constitute investment advice.