Investors fear resilient US stocks fail to factor in a possible recession

US stocks have soldiered on through a banking mess to notch solid first-quarter gains. Some investors say that performance could come under pressure if a widely expected recession hits.

The benchmark S&P 500 posted a 7 per cent gain for the first quarter, which ended on Friday, rebounding after a nearly 20 per cent drop in 2022. The Nasdaq Composite's 16.8 per cent first-quarter jump was its biggest quarterly increase since 2020.

Wary investors say those gains leave stocks more vulnerable to an economic downturn, which may have been brought closer by tumult in the banking sector after last month’s collapse of Silicon Valley Bank.

Many point to equity valuations, which by historical standards are still elevated, while arguing that corporate earnings may have a long way to fall in the event of a recession.

“The answer is emphatically no, the market is not priced for a recession at all,” said Hans Olsen, chief investment officer at Fiduciary Trust, which is guarding against future market turbulence by holding higher than typical amounts of cash.

For stocks, “it means that we could be in for some very nasty surprises over the coming quarters".

To what degree equities have factored in a possible recession — and whether the economy will experience one — is a point of contention on Wall Street.

Strong data earlier in the year bolstered hopes that the US would suffer only a mild recession or avoid one altogether, despite a barrage of rate increases from the Federal Reserve.

The banking sector turbulence again revved up concerns, as some analysts said the stress on lenders could pressure the economy just as the Fed’s monetary policy tightening is starting to bite.

That’s pushed investors to take a second look at key metrics such as corporate earnings. While estimates for profits are already downbeat for the coming quarters, some believe they may fall further if there is a recession.

"Given the events of the past few weeks, we think ... equity markets are at greater risk of pricing in much lower estimates," Morgan Stanley strategists said in a report this week, noting that earnings estimates were 15 per cent to 20 per cent too high even "before the recent banking events".

S&P 500 earnings for the first quarter are estimated to have fallen 5 per cent from the previous year, followed by an expected 3.9 per cent drop in the second quarter, Refinitiv data shows. During recessions, however, earnings tumble at a 24 per cent annual rate on average, according to Ned Davis Research.

US companies will start reporting first-quarter results in the coming weeks.

Valuations for stocks overall are also historically high, with the S&P 500 trading at about 18 times forward earnings estimates compared with its long-term average price-equity ratio of 15.6 times, according to Refinitiv Datastream.

Nathan Shetty, head of multi-asset at Nuveen, believes current valuations show investors have yet to price in a recession.

"If the market was looking through this and saying, 'OK, recession is likely to occur', you would start to see those valuations start to come down a bit rather than being as elevated as they are,” he said.

Investors are looking to next week's monthly payrolls report for a read on the strength of a labour market that has shown resiliency over the past year.

Some investors say stocks may have priced in a recession during last year’s steep decline, during which the S&P 500 fell by as much as 25.4 per cent from its all-time high to when it reached its October nadir.

Such a drop is broadly in line with historical data from Truist Advisory Services, showing the index has fallen an average of 29 per cent during recessions since the Second World War.

"Do we have to price in the same recession twice? Likely not, but that is not to say that the coast is clear yet,” said Angelo Kourkafas, an investment strategist at Edward Jones. Kourkafas believes stocks could face turbulence ahead but are unlikely to fall through their October lows.

Other variables could determine how markets react to an economic downturn, including its severity and length. Another is whether the Fed begins cutting rates when a downturn hits or keeps them elevated to finish off its fight against inflation.

Although the central bank’s outlook shows borrowing costs remaining at current levels by year end, investors in futures markets see rates falling in the second half of the year.

“Once the market gets visibility into the timing on those rate reductions, notwithstanding a recession, I don’t think that you are going to see a lot of downward movement in stocks,” said Tony Roth, chief investment officer for Wilmington Trust.